Discussion paper

DP15717 Model Complexity, Expectations, and Asset Prices

This paper analyzes how limits to the complexity of statistical models used by market participants can shape asset prices. We consider an economy in which agents can only entertain models with at most k factors, where k may be distinct from the true number of factors that drive
the economy’s fundamentals. We first characterize the implications of the resulting departure from rational expectations for return dynamics and relate the extent of return predictability at various horizons to the number of factors in the agents’ models and the statistical properties
of the underlying data-generating process. We then apply our framework to two applications in asset pricing: (i) violations of uncovered interest rate parity at different horizons and (ii) momentum and reversal in equity returns. We find that constraints on the complexity of agents’ models can generate return predictability patterns that are consistent with the data.


Molavi, P, A Tahbaz-Salehi and A Vedolin (2021), ‘DP15717 Model Complexity, Expectations, and Asset Prices‘, CEPR Discussion Paper No. 15717. CEPR Press, Paris & London. https://cepr.org/publications/dp15717