Can Market Risk Perception Drive Inefficient Prices? Theory and Evidence

TL;DR

This paper develops an asset pricing model demonstrating how market risk perception influences price efficiency, supported by empirical evidence from the S&P 500 during the Dot.com bubble, highlighting the link between risk perception and market anomalies.

Contribution

It introduces a theoretical model showing how risk perception affects price efficiency and provides empirical validation using S&P 500 data during a market bubble.

Findings

Higher risk perception leads to less efficient prices.

The model explains increased risk premiums during bubbles.

Empirical data supports the existence of inefficient equilibrium prices.

Abstract

This work presents an asset pricing model that under rational expectation equilibrium perspective shows how, depending on risk aversion and noise volatility, a risky-asset has one equilibrium price that differs in term of efficiency: an informational efficient one (similar to Campbell and Kyle (1993)), and another one where price diverges from its informational efficient level. The former Pareto dominates (is dominated by) the latter in presence of low (high) market risk perception. The estimates of the model using S&P 500 Index support the theoretical findings, and the estimated inefficient equilibrium price captures the higher risk premium and higher volatility observed during the Dot.com bubble 1995--2000.