Asset Prices When Investors Underestimate Discount Rate Dynamics

Underestimating discount rate volatility leads to asset pricing anomalies. Using
analysts’ return forecasts as proxies for subjective discount rates, I show that these
forecasts exhibit systematically lower volatility than CAPM-based benchmarks,
whose objective fluctuations negatively predict future returns, especially for high
beta-volatility stocks. A misvaluation measure based on this underestimation
significantly predicts cross-sectional CAPM alphas, while a tradable factor explains
12 prominent anomalies. These findings underscore discount rate underestimation
as a unifying explanation for analysts’ forecast errors and cross-sectional return
predictability, linking recent evidence on aggregate subjective belief dynamics with
firm-level mispricing.