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Higher Order Expectations in Asset Pricing

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Author Info
Philippe BACCHETTA (Study Center of Gerzensee, University of Lausanne and CEPR)
Eric VAN WINCOOP (University of Virginia and NBER)

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Abstract

In this paper, 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. In a dynamic noisy rational expectations model, higher order expectations add an additional term, which we call the higher order wedge, to a standard asset pricing equation. Consistent with Keynes' reasoning we show that investment decisions are based not just on expected future payoffs, but also on anticipated future expectational errors made by the market. The latter are captured by the higher order wedge. We show that the expectation of future expectational errors by the market is perfectly rational when investors have both noisy public and private information. The main effect of this additional asset pricing term is to disconnect the price from the present value of future payoffs. We show that this effect can be quantitatively significant.

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Publisher Info
Paper provided by International Center for Financial Asset Management and Engineering in its series FAME Research Paper Series with number rp110.

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Date of creation: May 2004
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Handle: RePEc:fam:rpseri:rp110

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Related research
Keywords: Beauty contest; Heterogeneous information;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information

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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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    Other versions:
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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. 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!]
  2. 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)
  3. 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!]
  4. John Williamson, 2008. "Exchange Rate Economics," Peterson Institute Working Paper Series WP08-3, Peterson Institute for International Economics. [Downloadable!]
  5. Giovanni Cespa & Xavier Vives, 2008. "Dynamic Trading and Asset Prices: Keynes vs. Hayek," CSEF Working Papers 191, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy. [Downloadable!]
    Other versions:
  6. Axel Lindner, 2008. "Evaluating communication strategies for public agencies: transparency, opacity, and secrecy," IWH Discussion Papers 8-08, Halle Institute for Economic Research. [Downloadable!]
  7. Guido Lorenzoni, 2007. "News Shocks and Optimal Monetary Policy," NBER Working Papers 12898, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. 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!]
  9. 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:
  10. John Williamson, 2009. "Exchange Rate Economics," Open Economies Review, Springer, vol. 20(1), pages 123-146, February. [Downloadable!] (restricted)
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