Asset Pricing and Welfare Analysis with Bounded Rational Investors

Authors

  • Lei Lu

    Corresponding author
    1. Shanghai University of Finance and Economics
      Corresponding author: School of Finance, Shanghai University of Finance and Economics, 777 Guoding Road, Shanghai, 200433, China; Phone: +86-21-6590-4161; Fax: +86-21-6510-3925; E-mail: lu.lei@mail.shufe.edu.cn.
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  • 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.

Corresponding author: School of Finance, Shanghai University of Finance and Economics, 777 Guoding Road, Shanghai, 200433, China; Phone: +86-21-6590-4161; Fax: +86-21-6510-3925; E-mail: lu.lei@mail.shufe.edu.cn.

Abstract

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.

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