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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
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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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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.:
  1. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September. [Downloadable!] (restricted)
  2. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, vol. 50(5), pages 1163-81, September. [Downloadable!] (restricted)
  3. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1990. "Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation," NBER Working Papers 3250, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Hua He & Jiang Wang, 1995. "Differential Information and Dynamic Behavior of Stock Trading Volume," NBER Working Papers 5010, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Hyun Song Shin & Andrew Postlewaite & Stephen Morris, 1995. "Depth of knowledge and the effect of higher order uncertainty," Economic Theory, Springer, vol. 6(3), pages 453-467.
    Other versions:
  6. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, vol. 71(1), pages 173-204, January. [Downloadable!] (restricted)
    Other versions:
  7. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  8. Biais, Bruno & Bossaerts, Peter, 1998. "Asset Prices and Trading Volume in a Beauty Contest," Review of Economic Studies, Blackwell Publishing, vol. 65(2), pages 307-40, April. [Downloadable!] (restricted)
  9. 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:
  10. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February. [Downloadable!] (restricted)
  11. Allen F. & Morris S. & Postlewaite A., 1993. "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 61(2), pages 206-229, December. [Downloadable!] (restricted)
  12. He, Hua & Wang, Jiang, 1995. "Differential Information and Dynamic Behavior of Stock Trading Volume," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 8(4), pages 919-72. [Downloadable!] (restricted)
  13. Samet, Dov, 1998. "Iterated Expectations and Common Priors," Games and Economic Behavior, Elsevier, vol. 24(1-2), pages 131-141, July. [Downloadable!] (restricted)
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  15. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December. [Downloadable!]
  16. Franklin Allen & Stephen Morris & Andrew Postlewaite, . "Finite Bubbles with Short Sale Constraints and Asymmetric Information (Reprint 042)," Rodney L. White Center for Financial Research Working Papers 16-92, Wharton School Rodney L. White Center for Financial Research.
  17. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June. [Downloadable!] (restricted)
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  19. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April. [Downloadable!] (restricted)
  20. Joseph G. Pearlman & Thomas J. Sargent, 2005. "Knowing the Forecasts of Others," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 480-497, April. [Downloadable!] (restricted)
  21. Harrison, J Michael & Kreps, David M, 1978. "Speculative Investor Behavior in a Stock Market with Heterogeneous Expectations," The Quarterly Journal of Economics, MIT Press, vol. 92(2), pages 323-36, May. [Downloadable!] (restricted)
  22. Townsend, Robert M, 1983. "Forecasting the Forecasts of Others," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 546-88, August. [Downloadable!] (restricted)
  23. Townsend, Robert M, 1978. "Market Anticipations, Rational Expectations, and Bayesian Analysis," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 19(2), pages 481-94, June. [Downloadable!] (restricted)
  24. Allen, Franklin & Gorton, Gary, 1993. "Churning Bubbles," Review of Economic Studies, Blackwell Publishing, vol. 60(4), pages 813-36, October. [Downloadable!] (restricted)
  25. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "Positive Feedback Investment Strategies and Destabilizing Rational Speculation," NBER Working Papers 2880, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  26. Christian Hellwig, 2002. "Public Announcements, Adjustment Delays, and the Business Cycle (November 2002)," UCLA Economics Online Papers 208, UCLA Department of Economics. [Downloadable!]
  27. Dow, James & Gorton, Gary, 1994. " Arbitrage Chains," Journal of Finance, American Finance Association, vol. 49(3), pages 819-49, July. [Downloadable!] (restricted)
    Other versions:
  28. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June. [Downloadable!] (restricted)
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