Noise, risk premium, and bubble

TL;DR

This paper links market risk premiums and asset price anomalies to an ambient information process with noise, explaining phenomena like equity premiums and bubbles through the dynamics of the noise component.

Contribution

It introduces a model where noise-driven information processes influence asset prices and risk premiums, providing a new explanation for bubbles and equity premiums.

Findings

Noise in information processes affects asset price dynamics.

Drifts in noise can induce financial bubbles.

Explains observed equity premium phenomena.

Abstract

The existence of the pricing kernel is shown to imply the existence of an ambient information process that generates market filtration. This information process consists of a signal component concerning the value of the random variable X that can be interpreted as the timing of future cash demand, and an independent noise component. The conditional expectation of the signal, in particular, determines the market risk premium vector. An addition to the signal of any term that is independent of X, which generates a drift in the noise, is shown to change the drifts of price processes in the physical measure, without affecting the current asset price levels. Such a drift in the noise term can induce anomalous price dynamics, and can be seen to explain the mechanism of observed phenomena of equity premium and financial bubbles.