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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

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Author Info
Franklin Allen (Wharton School, University of Pennsylvania)
Stephen Morris (Cowles Foundation, Yale University)
Hyun Song Shin (London School of Economics)

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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 and explain over-reaction to (noisy) public information.

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File URL: http://cowles.econ.yale.edu/P/cd/d14a/d1406.pdf
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Publisher Info
Paper provided by Cowles Foundation, Yale University in its series Cowles Foundation Discussion Papers with number 1406.

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Length: 37 pages
Date of creation: Mar 2003
Date of revision:
Publication status: Published in Review of Financial Studies (2006), 19: 719-752
Handle: RePEc:cwl:cwldpp:1406

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Related research
Keywords: Beauty Contests Bubbles and iterated expectations in Asset Markets

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Find related papers by JEL classification:
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

This paper has been announced in the following NEP Reports:

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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    Other versions:
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    Other versions:
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    Other versions:
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Full references

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. Keiichiro Kobayashi, 2006. "Transaction services and asset-price bubbles (Revised)," Discussion papers 06010, Research Institute of Economy, Trade and Industry (RIETI). [Downloadable!]
  2. Jeffery D. Amato & Hyun Song Shin, . "Public and Private Information in Monetary Policy Models," DNB Staff Reports (discontinued) 117, Netherlands Central Bank. [Downloadable!]
  3. Hale, Galina B & Razin, Assaf & Tong, Hui, 2006. "Institutional Weakness and Stock Price Volatility," CEPR Discussion Papers 5651, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  4. 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!]
  5. Bacchetta, Philippe & van Wincoop, Eric, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," CEPR Discussion Papers 3808, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  6. Antonio Bernardo & Ivo Welch, 2002. "Financial Market Runs," University of California at Los Angeles, Anderson Graduate School of Management 1043, Anderson Graduate School of Management, UCLA. [Downloadable!]
    Other versions:
  7. Spyros Pagratis, . "Asset pricing, asymmetric information and rating announcements: does benchmarking on ratings matter?," Bank of England working papers 265, Bank of England. [Downloadable!]
  8. Todd B. Walker, 2005. "How Equilibrium Prices Reveal Information in Time Series Models with Disparately Informed, Competitive Traders," Finance 0509021, EconWPA. [Downloadable!]
    Other versions:
  9. Christian Hellwig, 2005. "Knowing What Others Know: Coordination Motives in Information Acquisition (March 2007, with Laura Veldkamp)," UCLA Economics Online Papers 369, UCLA Department of Economics. [Downloadable!]
  10. Jürgen Huber & Matthias Sutter & Michael Kirchler, 2004. "Is more information always better? Experimental financial markets with asymmetric information," Discussion Papers on Strategic Interaction 2005-13, Max Planck Institute of Economics, Strategic Interaction Group. [Downloadable!]
  11. Hyun Song Shin & Jeffery D. Amato, 2003. "Public and Private Information in Monetary Policy Models," Computing in Economics and Finance 2003 38, Society for Computational Economics. [Downloadable!]
  12. Philippe Bacchetta & Eric van Wincoop, 2004. "Higher Order Expectations in Asset Pricing," Working Papers 04.03, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
    Other versions:
  13. Keiichiro Kobayashi, 2004. "Transaction services and asset-price bubbles," Discussion papers 04026, Research Institute of Economy, Trade and Industry (RIETI). [Downloadable!]
  14. Amil Dasgupta & Andrea Prat, 2005. "Reputation and Asset Prices: A Theory of Information Cascades and Systematic Mispricing," Levine's Bibliography 784828000000000368, UCLA Department of Economics. [Downloadable!]
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  16. José M. Marín & Jacques Olivier, 2006. "The Dog That Did Not Bark: Insider Trading and Crashes," Economics Working Papers 948, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
    Other versions:
  17. Guido Lorenzoni, 2006. "A Theory of Demand Shocks," NBER Working Papers 12477, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  18. Juan Dubra & Helios Herrera, 2002. "Market Participation, Information and Volatility," Working Papers 0206, Centro de Investigacion Economica, ITAM. [Downloadable!]
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