Extrapolative Asset Pricing

Abstract

We study asset pricing implications of return extrapolation in a Lucas economy. We find that the effect of extrapolation is mainly on short rates rather than risk premia, time variation in expected returns is mainly driven by time-varying short rates, and return volatility can be lower than consumption volatility. Therefore, return extrapolation documented in survey expectations literature does not help resolve asset pricing puzzles. Our findings are different from Barberis, Greenwood, Jin and Shleifer (2015) who study price extrapolation and assume an exogenous short rate. Our results highlight the subtle differences of price extrapolation and return extrapolation.