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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

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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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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, 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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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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Keywords: Beauty Contests; Bubbles and iterated expectations in Asset Markets;

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