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Higher Order Expectations in Asset Pricing

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Author Info
Bacchetta, Philippe
van Wincoop, Eric

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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. Higher order expectations add an additional term to a standard asset pricing equation. 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 higher order wedge depends on first order expectational errors about the mean set of private signals. This in turn depends on expectational errors about future asset payoffs based on errors in public signals. We show that the higher order 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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6648.

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Date of creation: Jan 2008
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Handle: RePEc:cpr:ceprdp:6648

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Related research
Keywords: Asset pricing; Beauty contest; Higher order beliefs;

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Find related papers by JEL classification:
D8 - Microeconomics - - Information, Knowledge, and Uncertainty
G0 - Financial Economics - - General
G1 - Financial Economics - - General Financial Markets

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References listed on IDEAS
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.:
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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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