Intrinsic Bubbles and Fat Tails in Stock Prices

Abstract

We study the constant discount rate present value model for stock pricing in a stochastic setting where the exogenous dividend stream is modeled as a random walk with innovations drawn from the family of stable distributions. We derive an exact analytical solution for the fundamental stock price. We evaluate the ability of the model fundamentals and the dividends-driven intrinsic bubbles to explain the observed variation in annual US stock prices. We compare results obtained in this setting with those from the traditional model where all stochastic processes are driven by Gaussian shocks.Stock prices, present-value model, intrinsic bubbles, fat tails, normal distributions, stable distributions