Risk preference and stability under learning

- Speculative bubbles are triggered by reactions to expected returns and volatility.
- The incidence of bubbles is increasing in the strength of risk preferences.
- Other factors include memory, learning rate, and sophistication of forecast rules.
- Bubbles may emerge even if traders employ minimum state variable forecast rules.

We consider a simple market environment in which traders with finite memory update forecasting rules at random intervals by OLS. In this context, changes in the perception of market risk can trigger volatility and bubbles. Consequently, higher degrees of risk response among traders can have a destabilizing effect on price dynamics. We consider the interaction of this effect with memory, the speed of learning, and the nature of the forecasting rules.