Volatility Under Bounded Rationality

The ARCH model shares with the related literature on risk and return one common thing: rational-expectation paradigm. In particular, market prices should reflect investors' rational forecasts based on the best available information. When new information arrives, the market's expectations change. Therefore, prices fluctuate. Thus, price volatility is due to information arrivals and hence, volatility can be forecast, based on the up-to-date information. However, when the available information is too complex, rational expectation may no longer hold. Bounded rationality should be added into our frame work to study risk and return, so that, we can gain a better understanding of market volatility.