An Equilibrium Theory of Excess Volatility and Mean Reversion in Stock Market Prices

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Apparent mean reversion and excess volatility in stock market prices can be reconciled with the Efficient Market Hypothesis by specifying investor preferences that give rise to the demand for portfolio insurance. Therefore, several supposed macro anomalies can be shown to be consistent with a rational market in a simple and parsimonious model of the economy. Unlike other models that have derived equilibrium mean reversion in prices, the model in this paper does not require that the production side of the economy exhibit mean reversion. It also predicts that mean reversion and excess volatility will differ substantially across subperiods.

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