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Higher Order Expectations in Asset Pricing

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Author Info
Philippe Bacchetta () (University of Lausanne, Studienzentrum Gerzensee and CEPR)
Eric van Wincoop () (University of Virginia)

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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 signiffcant.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 04.03.

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Length: 39
Date of creation: May 2004
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Handle: RePEc:szg:worpap:0403

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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. 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)
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  5. 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)
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  9. Barberis, Nicholas & Thaler, Richard, 2003. "A survey of behavioral finance," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 18, pages 1053-1128 Elsevier. [Downloadable!] (restricted)
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  16. Michael J. Brennan. and H. Henry Cao., 1997. "International Portfolio Investment Flows," Research Program in Finance Working Papers RPF-271, University of California at Berkeley. [Downloadable!]
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  18. 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)
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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. 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!]
  3. John Williamson, 2008. "Exchange Rate Economics," Peterson Institute Working Paper Series WP08-3, Peterson Institute for International Economics. [Downloadable!]
  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!]
    Other versions:
  5. Cespa, Giovanni & Vives, Xavier, 2007. "Dynamic trading and asset prices: Keynes vs. Hayek," IESE Research Papers D/716, IESE Business School. [Downloadable!]
    Other versions:
  6. 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!]
  7. Axel Lindner, 2008. "Evaluating communication strategies for public agencies: transparency, opacity, and secrecy," IWH Discussion Papers 8-08, Halle Institute for Economic Research. [Downloadable!]
  8. Guido Lorenzoni, 2007. "News Shocks and Optimal Monetary Policy," NBER Working Papers 12898, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  9. 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!]
  10. John Williamson, 2009. "Exchange Rate Economics," Open Economies Review, Springer, vol. 20(1), pages 123-146, February. [Downloadable!] (restricted)
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