Excess Volatility

Question 1

Shiller (1981)

Answer 1

Analysed 1987 crash–> 22% fall in US GDP

Surveyed/Interviewed bankers and investors –> suggest now fundamental change during crash

examine NPV of future cashflows to firms, found that shifts in dividends are far less volatile than actual prices

Question 2

Explanation - Disasters

Answer 2

Barro 2006: Equity and volatility puzzles solved by disasters

• -> 20th Centuty disasters –> any shock that makes GDP fall by >15%
• -> catalogue 60 w/ mean decline of 29%

–> Found that almost OECD countries (exc swiss) suffered major disaster during 20th C

Given CRRA=4
–>He applies a disaster probabilty of 1.7%, w/ default probability of 40% during disaster he gets equity risk premium of 5.4% as opposed to 0.24%

stochastic persistance of variety in the probability of disaster can lead to high volatiliy –> risk of random future disaster raises rq return–> assumes consumers are very forward looking and consider future probability of disasters–> optimistic at best

Question 3

Behavioural - Feedback Models

Answer 3

Shiller (2003): Price to price feedback theory
Animal spirits drive price up–> success encourages a a fad–> fad drives more demand –> prices increase–> creates a loop eventually leads to a bubble (e.g. Dutch Tulip bubble)

Evidence suggests bubbles tend to form if people are conditioned to expect them–>rational investors try to capitalise on the bubble driving more demand–> increases incentive to buy in and sell before burst (secondary feedback effect)

Question 4

Behavioural - Pattern Recognition

Answer 4

Kalineman & Traversky (1974): Inv. decisions based on representative heuristics
–> make predictions based on closest pattern to previous patterns w/o paying attention to likelihood that new event will follow last pattern