Learning about Risk and Return: A Simple Model of Bubbles and Crashes

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they generate forecasts of the conditional variance of a stock's return. Recursive updating of the conditional variance and expected return implies two mechanisms through which learning impacts stock prices: occasional shocks may lead agents to lower their risk estimate and increase their expected return, thereby triggering a bubble; along a bubble path recursive estimates of risk will increase and crash the bubble.