Asset Pricing Inefficiencies : The Key Role Played by Fundamentalists’ Mistakes on Risk Premia and a Faulty Learning Process

Three key variables determine the fair value estimates for financial assets: the current and future payoffs provided by the asset, the current and future short-term interest rates controlled by central banks, and the current and future excess returns - or short-term risk premia - required by investors. Although they all contribute to present value calculations in very similar ways, a fundamental difference exists among these variables: while the current returns paid by assets and the short-term interest rates are known, the short-term risk premia remain private information. Despite the availability of some surveys, fundamentalists inevitably make mistakes when estimating this crucial variable.When these errors are significant and persist over time, a "conundrum" surfaces in the markets. The resulting signals are often challenging to interpret, leading to a loss of confidence in fundamentalist asset pricing and chaotic price overshooting. In this paper, we theoretically discuss this critical mechanism, which, to our knowledge, has not been identified previously. We illustrate how the concept of "fundamentalists’ capitulation" aids in understanding certain enigmatic episodes in the history of US Treasuries and the equities market.Risk premia change and this is one of the main reasons markets are volatile. However, we argue that such disorderly and costly learning processes are not inevitable. A better understanding of the “market failures” at work (bounded rationality and private information) could help fundamentalists use information about current risk premia more effectively and keep the control of markets