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Higher Order Expectations in Asset Pricing

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Author Info
PHILIPPE BACCHETTA
ERIC VAN WINCOOP

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Abstract

We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price in the context of a dynamic noisy rational expectations model. We show that the wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large. Copyright (c) 2008 The Ohio State University.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1538-4616.2008.00139.x
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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 40 (2008)
Issue (Month): 5 (08)
Pages: 837-866
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Handle: RePEc:mcb:jmoncb:v:40:y:2008:i:5:p:837-866

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  1. Hua He & Jiang Wang, 1995. "Differential Information and Dynamic Behavior of Stock Trading Volume," NBER Working Papers 5010, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  2. Jeffery Amato & Hyun Song Shin, 2003. "Public and Private Information in Monetary Policy Models," Levine's Bibliography 666156000000000092, UCLA Department of Economics. [Downloadable!]
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  7. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128 Elsevier. [Downloadable!] (restricted)
    Other versions:
  8. Brennan, Michael J & Cao, H Henry, 1997. " International Portfolio Investment Flows," Journal of Finance, American Finance Association, vol. 52(5), pages 1851-80, December. [Downloadable!] (restricted)
  9. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February. [Downloadable!] (restricted)
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  14. Michael J. Brennan. and H. Henry Cao., 1997. "International Portfolio Investment Flows," Research Program in Finance Working Papers RPF-271, University of California at Berkeley. [Downloadable!]
  15. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June. [Downloadable!] (restricted)
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  16. Joseph G. Pearlman & Thomas J. Sargent, 2005. "Knowing the Forecasts of Others," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 480-497, April. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Min Fan, 2006. "Heterogeneous Beliefs, the Term Structure and Time-varying Risk Premia," Annals of Finance, Springer, vol. 2(3), pages 259-285, July. [Downloadable!] (restricted)
  2. Cespa, Giovanni & Vives, Xavier, 2007. "Dynamic trading and asset prices: Keynes vs. Hayek," IESE Research Papers D/716, IESE Business School. [Downloadable!]
    Other versions:
  3. John Williamson, 2009. "Exchange Rate Economics," Open Economies Review, Springer, vol. 20(1), pages 123-146, February. [Downloadable!] (restricted)
  4. Pierre Monnin, . "Are stock markets really like beauty contests? Empirical evidence of higher order belief's impact on asset prices," IEW - Working Papers iewwp202, Institute for Empirical Research in Economics - IEW. [Downloadable!]
  5. John Williamson, 2008. "Exchange Rate Economics," Peterson Institute Working Paper Series WP08-3, Peterson Institute for International Economics. [Downloadable!]
  6. Katrin Tinn, 2005. "Optimal research in financial markets with heterogeneous private information; a rational expectations model," Money Macro and Finance (MMF) Research Group Conference 2005 6, Money Macro and Finance Research Group. [Downloadable!]
    Other versions:
  7. Enrique Martinez-Garcia, 2007. "A monetary model of the exchange rate with informational frictions," Globalization and Monetary Policy Institute Working Paper 02, Federal Reserve Bank of Dallas. [Downloadable!]
  8. Axel Lindner, 2008. "Evaluating communication strategies for public agencies: transparency, opacity, and secrecy," IWH Discussion Papers 8-08, Halle Institute for Economic Research. [Downloadable!]
  9. Guido Lorenzoni, 2007. "News Shocks and Optimal Monetary Policy," NBER Working Papers 12898, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  10. Kurz, Mordecai, 2006. "Beauty contests under private information and diverse beliefs: how different?," MPRA Paper 233, University Library of Munich, Germany, revised Apr 2006. [Downloadable!]
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