Advanced Search
MyIDEAS: Login

Social States of Belief and the Determinants of the Equity Risk Premium in A Rational Belief Equilibrium

Contents:

Author Info

  • Mordecai Kurz
Registered author(s):

    Abstract

    September 4, 1997 We review the issues related to the formulation of endogenous uncertainty in rational belief equilibria(RBE). In all previous models of RBE, individual states of belief were the foundation for the construction of the endogenous state space where individual states of belief were described with the method of assessment variables. This approach leads to a lack of "anonymity" where the belief of each individual agent has an impact on equilibrium prices but as a competitor he ignores it. The solution is to study a replica economy with a finite number of types but with a large number of agents of each type. This gives rise to "type-states" which are distributions of beliefs within each type. The state space for this economy is then constructed as the set of products of the exogenous states and the social states of belief which are vectors of distributions of all the types. Such an economy leads to RBE which do indeed solve the problem of anonymity. We then study via simulations the implications of the model of RBE with social states for market volatility and for the determinants of the equity risk premium in an RBE. Under i.i.d. assessments one uses the law of large numbers to induce a single social state of belief and we show that the RBE of such economies have the same number of prices as in rational expectations equilibrium (REE). However, the RBE may exhibit large fluctuations if agents are allowed to hold extreme beliefs. Establishing 5% boundary restrictions on beliefs we show that the model with a single social state of belief cannot explain all the moments of the observed distribution of returns. We then introduce correlation among beliefs and this leads to the creation of new social states. We next show that under correlation among beliefs the model simulations reproduce the values of four key moments of the empirical distribution of returns. The observed equity premium is then explained by two factors. First, investors demand a higher risk premium to compensate them for the endogenous increase in the volatility of returns. Second, at any moment of time there are both rational optimists as well as rational pessimists in our financial markets and such a distribution leads automatically to a decrease in the riskless rate and to an increase of the risk premium. We show that correlation among beliefs of agents leads to fluctuations over time in the social distribution of beliefs and such fluctuations add to endogenous volatility and to a higher equilibrium equity risk premium. JEL Classification Numbers: D58, D84, G12.

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://www-econ.stanford.edu/faculty/workp/swp97026.pdf
    Download Restriction: no

    Bibliographic Info

    Paper provided by Stanford University, Department of Economics in its series Working Papers with number 97026.

    as in new window
    Length:
    Date of creation: 04 Sep 1997
    Date of revision:
    Handle: RePEc:wop:stanec:97026

    Contact details of provider:
    Postal: Ralph Landau Economics Building, Stanford, CA 94305-6072
    Phone: (650)-725-3266
    Fax: (650)-725-5702
    Email:
    Web page: http://www-econ.stanford.edu/econ/workp/
    More information through EDIRC

    Related research

    Keywords:

    Find related papers by JEL classification:

    References

    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.:
    as in new window
    1. Steven N. Durlauf, 1991. "Nonergodic Economic Growth," NBER Working Papers 3719, National Bureau of Economic Research, Inc.
    2. Mordecai Kurz & Martin Schneider, 1996. "Coordination and correlation in Markov rational belief equilibria (*)," Economic Theory, Springer, vol. 8(3), pages 489-520.
    3. Carsten Krabbe Nielsen, 1995. "Rational Belief Structures and Rational Belief Equilibrium," Discussion Papers 95-14, University of Copenhagen. Department of Economics.
    4. William A. Brock, 1993. "Pathways to randomness in the economy: Emergent nonlinearity and chaos in economics and finance," Estudios Económicos, El Colegio de México, Centro de Estudios Económicos, vol. 8(1), pages 3-55.
    5. Scharfstein, David S & Stein, Jeremy C, 1990. "Herd Behavior and Investment," American Economic Review, American Economic Association, vol. 80(3), pages 465-79, June.
    6. N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
    7. Brock,W.A. & Durlauf,S.N., 2000. "Discrete choice with social interactions," Working papers 7, Wisconsin Madison - Social Systems.
    8. Willaiam A. Brock, 1996. "Asset Price Behavior in Complex Environments," Working Papers 96-04-018, Santa Fe Institute.
    9. Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
    10. Follmer, Hans, 1974. "Random economies with many interacting agents," Journal of Mathematical Economics, Elsevier, vol. 1(1), pages 51-62, March.
    11. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
    12. Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 2010. "A theory of Fads, Fashion, Custom and cultural change as informational Cascades," Levine's Working Paper Archive 1193, David K. Levine.
    13. Ho-Mou Wu & Mordecai Kurz, 1996. "Endogenous uncertainty in a general equilibrium model with price contingent contracts (*)," Economic Theory, Springer, vol. 8(3), pages 461-488.
    14. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    15. William A. Brock & Steven N. Durlauf, 1995. "Discrete Choice with Social Interactions I: Theory," NBER Working Papers 5291, National Bureau of Economic Research, Inc.
    16. Mordecai Kurz & Ho-Mou Wu, . "Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts," Working Papers 96002, Stanford University, Department of Economics.
    17. Brock, William & Lakonishok, Josef & LeBaron, Blake, 1992. " Simple Technical Trading Rules and the Stochastic Properties of Stock Returns," Journal of Finance, American Finance Association, vol. 47(5), pages 1731-64, December.
    18. Philippe Henrotte, 1996. "Construction of a state space for interrelated securities with an application to temporary equilibrium theory (*)," Economic Theory, Springer, vol. 8(3), pages 423-459.
    19. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    20. Malinvaud, E., 1972. "The allocation of individual risks in large markets," Journal of Economic Theory, Elsevier, vol. 4(2), pages 312-328, April.
    21. Kurz, Mordecai & Wu, Ho-Mou, 1996. "Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts," Economic Theory, Springer, vol. 8(3), pages 461-88, October.
    22. Cass, David & Chichilnisky, Graciela & Wu, Ho-Mou, 1996. "Individual Risk and Mutual Insurance," Econometrica, Econometric Society, vol. 64(2), pages 333-41, March.
    23. repec:att:wimass:9606 is not listed on IDEAS
    24. Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, vol. 47(3), pages 655-78, May.
    25. Malinvaud, E, 1973. "Markets for an Exchange Economy with Individual Risks," Econometrica, Econometric Society, vol. 41(3), pages 383-410, May.
    26. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
    27. Svensson, Lars E O, 1981. "Efficiency and Speculation in a Model with Price-Contingent Contracts," Econometrica, Econometric Society, vol. 49(1), pages 131-51, January.
    28. Henrotte, Philippe, 1996. "Construction of a State Space for Interrelated Securities with an Application to Temporary Equilibrium Theory," Economic Theory, Springer, vol. 8(3), pages 423-59, October.
    Full references (including those not matched with items on IDEAS)

    Citations

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:wop:stanec:97026. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.