Confidence Risk and Asset Prices

Abstract

In the data, asset prices exhibit large negative moves at frequencies of about 18 months. These large moves are puzzling as they do not coincide, nor are they followed by any significant moves in the real side of the economy. On the other hand, we find that measures of investor's uncertainty about their estimate of future growth have significant information about large moves in returns. We set-up a recursive-utility based model in which investors learn about the latent expected growth using the cross-section of signals. The uncertainty (confidence measure) about investor's growth expectations, as in the data, is time-varying and subject to large moves. The fluctuations in confidence measure affect the distribution of future consumption given investors' information, and consequently influence equilibrium asset prices and risk premia. In calibrations we show that the model can account for the large return move evidence in the data, distribution of asset prices, predictability of excess returns and other key asset market facts.