Asset Prices When Investors Underestimate Discount Rate Dynamics

Abstract

Underestimating discount rate volatility leads to asset pricing anomalies. Usinganalysts’ return forecasts as proxies for subjective discount rates, I show that theseforecasts exhibit systematically lower volatility than CAPM-based benchmarks,whose objective fluctuations negatively predict future returns, especially for highbeta-volatility stocks. A misvaluation measure based on this underestimationsignificantly predicts cross-sectional CAPM alphas, while a tradable factor explains12 prominent anomalies. These findings underscore discount rate underestimationas a unifying explanation for analysts’ forecast errors and cross-sectional returnpredictability, linking recent evidence on aggregate subjective belief dynamics withfirm-level mispricing