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The Dynamics of Efficient Asset Trading with Heterogeneous Beliefs

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  • Pablo F Beker
  • Emilio Espino

Abstract

This paper analyzes the dynamic properties of portfolios that sustain dynamically complete markets equilibrium when agents have heterogeneous priors. We argue that the conventional wisdom that belief heterogeneity generates continuous trade and significant fluctuations in individual portfolios may be correct but it needs some qualifications. We consider an infinite horizon stochastic endowment economy populated by many Bayesian agents with heterogeneous priors over the stochastic process of the states of nature. Our approach hinges on studying the portfolios that decentralize Pareto optimal allocations. Since these allocations are typically history dependent, we propose a methodology to provide a complete recursive characterization when agents believe that the process of states of nature is i.i.d. but disagree about the probability of the states. We show that even though heterogeneous priors within that class can indeed generate genuine changes in the portfolios of any dynamically complete markets equilibrium, these changes vanish with probability one if the true process consists of i.i.d. draws from a common distribution and the support of some agent's prior belief contains the true distribution. Finally, we provide examples in which asset trading does not vanish because either (i) no agent learns the true conditional probability of the states or (ii) some agent does not know the true process generating the data is i.i.d.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000001715.

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Date of creation: 19 Nov 2007
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Handle: RePEc:cla:levrem:122247000000001715

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  1. Harris, Milton & Raviv, Artur, 1993. "Differences of Opinion Make a Horse Race," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 6(3), pages 473-506.
  2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, Econometric Society, vol. 46(6), pages 1429-45, November.
  3. Lawrence Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Working Papers, Santa Fe Institute 01-06-031, Santa Fe Institute.
  4. Morris, Stephen, 1996. "Speculative Investor Behavior and Learning," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 111(4), pages 1111-33, November.
  5. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Growth with Many Consumers," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 518, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  6. Easley, David & Kiefer, Nicholas M, 1988. "Controlling a Stochastic Process with Unknown Parameters," Econometrica, Econometric Society, Econometric Society, vol. 56(5), pages 1045-64, September.
  7. Dilip Abreu & David Pearce & Ennio Stacchetti, 2010. "Towards a Theory of Discounted Repeated Games with Imperfect Monitoring," Levine's Working Paper Archive 199, David K. Levine.
  8. Alvaro Sandroni, 2000. "Do Markets Favor Agents Able to Make Accurate Predicitions?," Econometrica, Econometric Society, Econometric Society, vol. 68(6), pages 1303-1342, November.
  9. Emilio Espino & Thomas Hintermaier, 2009. "Asset trading volume in a production economy," Economic Theory, Springer, Springer, vol. 39(2), pages 231-258, May.
  10. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(3), pages 454-476, April.
  11. Phillips, Peter C B & Ploberger, Werner, 1996. "An Asymptotic Theory of Bayesian Inference for Time Series," Econometrica, Econometric Society, Econometric Society, vol. 64(2), pages 381-412, March.
  12. Blume, Lawrence & Easley, David, 2009. "The market organism: Long-run survival in markets with heterogeneous traders," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 33(5), pages 1023-1035, May.
  13. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1990. "Toward a Theory of Discounted Repeated Games with Imperfect Monitoring," Econometrica, Econometric Society, Econometric Society, vol. 58(5), pages 1041-63, September.
  14. Boud, John III, 1990. "Recursive utility and the Ramsey problem," Journal of Economic Theory, Elsevier, Elsevier, vol. 50(2), pages 326-345, April.
  15. Hong, Harrison & Stein, Jeremy, 2007. "Disagreement and the Stock Market," Scholarly Articles 2894690, Harvard University Department of Economics.
  16. Morris, Stephen, 1995. "The Common Prior Assumption in Economic Theory," Economics and Philosophy, Cambridge University Press, vol. 11(02), pages 227-253, October.
  17. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 92(2), pages 323-36, May.
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Cited by:
  1. Beker, Pablo & Chattopadhyay, Subir, 2010. "Consumption dynamics in general equilibrium: A characterisation when markets are incomplete," Journal of Economic Theory, Elsevier, Elsevier, vol. 145(6), pages 2133-2185, November.
  2. Chien, YiLi & Cole, Harold L. & Lustig, Hanno, 2014. "Implications of heterogeneity in preferences, beliefs and asset trading technologies for the macroeconomy," Working Papers, Federal Reserve Bank of St. Louis 2014-14, Federal Reserve Bank of St. Louis.
  3. YiLi Chien & Harold L. Cole & Hanno Lustig, 2014. "Implications of Heterogeneity in Preferences, Beliefs and Asset Trading Technologies for the Macroeconomy," NBER Working Papers 20328, National Bureau of Economic Research, Inc.
  4. Emilio Espino & Juan M. Sanchez, 2010. "Risk sharing, investment, and incentives in the neoclassical growth model," Economic Quarterly, Federal Reserve Bank of Richmond, Federal Reserve Bank of Richmond, issue 4Q, pages 399-416.

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