In this article the authors discuss aspects of investor confidence risk and asset prices. The central focus of the article is on the contention of the authors that large moves in the price of assets occurred once every 18 months and are not associated with current or future price moves in macro variables. A number of other topics are addressed including the role played by investor confidence in determining asset price, economic forecasts from the Survey of Professional Forecasters, and the distribution of returns.
We examine equilibrium models based on Epstein-Zin preferences in a framework where exogenous state variables which drive consumption and dividend dynamics follow affine jump diffusion processes. Equilibrium asset prices can be computed using a standard machinery of affine asset pricing theory by imposing parametric restrictions on market prices of risk, determined by preference and model parameters. We present a detailed example where large shocks (jumps) in consumption volatility translate into negative jumps in equilibrium prices
of the assets. This endogenous ”leverage effect” leads to significant premiums for out-of-the-money put options. Our model is thus able to produce an equilibrium ”volatility smirk” which realistically mimics that observed for index options.