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Beauty Contests and Iterated Expectations in Asset Markets

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Author Info
Franklin Allen
Stephen Morris
Hyun Song Shin

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Abstract

In a financial market where traders are risk averse and short lived and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not, in general, equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher-order beliefs in a fully rational asset pricing model. Copyright 2006, Oxford University Press.

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Article provided by Oxford University Press for Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 19 (2006)
Issue (Month): 3 ()
Pages: 719-752
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Handle: RePEc:oup:rfinst:v:19:y:2006:i:3:p:719-752

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  9. Stephen Morris & Hyun Song Shin, 2007. "Coordinating Expectations in Monetary Policy," Levine's Bibliography 321307000000000956, UCLA Department of Economics. [Downloadable!]
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  14. Bernard Dumas & Alexander Kurshev & Raman Uppal, 2005. "What Can Rational Investors Do About Excessive Volatility and Sentiment Fluctuations?," NBER Working Papers 11803, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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