I am grateful to Benjamin Croitoru for his constant encouragement and insightful guidance. I thank Arnold Cowan (a former editor), an anonymous referee, Susan Christoffersen, Pascal Francois, Kris Jacobs, Ali Lazrak, Mark Loewenstein, Stylianos Perrakis, Yingzi Zhu, and participants at the 2006 CORS/Optimization Days joint conference, the 2006 European meeting of the FMA, the 2008 China International Conference in Finance and the Peking University HSBC School of Business for helpful comments and suggestions. I acknowledge financial support from the Shanghai Pujiang Program and the 211 Project-China. This paper is based on Chapter 4 of my doctoral dissertation from McGill University, Canada.
Asset Pricing and Welfare Analysis with Bounded Rational Investors
Article first published online: 16 APR 2010
© 2010, The Eastern Finance Association
Volume 45, Issue 2, pages 485–499, May 2010
How to Cite
Lu, L. (2010), Asset Pricing and Welfare Analysis with Bounded Rational Investors. Financial Review, 45: 485–499. doi: 10.1111/j.1540-6288.2010.00257.x
- Issue published online: 16 APR 2010
- Article first published online: 16 APR 2010
- asset pricing;
- bounded rationality;
- general equilibrium
Motivated by the fact that investors have limited ability to process information, I model investors’ bounded rational behavior in processing information and investigate its implications for asset pricing. Investors can make mistakes in processing information and thus have inaccurate estimates of fundamentals. This process generates “bounded rational risk.” I find that the volatility of stock and bond return increases in the presence of bounded rational investors, which can help explain the excessive volatility puzzle. The stock-bond return correlation becomes time varying and even negative and rational investors benefit from the trading with bounded rational investors.