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Keywords:

  • asset pricing;
  • bounded rationality;
  • general equilibrium
  • C60;
  • D50;
  • D83;
  • D90;
  • G12

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.