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Are stock markets really like beauty contests? Empirical evidence of higher order belief's impact on asset prices

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  • Pierre Monnin
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    Abstract

    The goal of this paper is to assess, for the first time, the empirical impact of "Keynes’ beauty contest", or "higher order beliefs", on asset price volatility. The paper shows that heterogeneous expectations induce higher order beliefs and that heterogeneous expectation asset pricing models theoretically generate more volatility than rational expectation models. The paper also explains how, with some assumptions on the distribution of public and private information, a model with higher order beliefs can be empirically estimated. The model is then applied to annual data of the American stock market. The results show that a model with higher order beliefs generates a level of volatility in line with the price volatility observed on the market.

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    Bibliographic Info

    Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 202.

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    Handle: RePEc:zur:iewwpx:202

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    Keywords: Asset pricing; Excess volatility; Higher order beliefs;

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    1. Biais, Bruno & Bossaerts, Peter, 1998. "Asset Prices and Trading Volume in a Beauty Contest," Review of Economic Studies, Wiley Blackwell, vol. 65(2), pages 307-40, April.
    2. 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.
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    7. Bruno Biais & Peter Bossaerts & Chester Spatt, 2003. "Equilibrium Asset Pricing Under Heterogeneous Information," Levine's Bibliography 666156000000000086, UCLA Department of Economics.
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    13. Franklin Allen & Stephen Morris & Hyun Song Shin, 2003. "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets," NajEcon Working Paper Reviews 391749000000000553, www.najecon.org.
    14. Zhong, Maosen & Darrat, Ali F. & Anderson, Dwight C., 2003. "Do US stock prices deviate from their fundamental values? Some new evidence," Journal of Banking & Finance, Elsevier, vol. 27(4), pages 673-697, April.
    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.
    16. Basak, Suleyman, 2000. "A model of dynamic equilibrium asset pricing with heterogeneous beliefs and extraneous risk," Journal of Economic Dynamics and Control, Elsevier, vol. 24(1), pages 63-95, January.
    17. Ho-Mou Wu & Wen-Chung Guo, 2004. "Asset price volatility and trading volume with rational beliefs," Economic Theory, Springer, vol. 23(4), pages 795-829, May.
    18. Miller, Edward M, 1977. "Risk, Uncertainty, and Divergence of Opinion," Journal of Finance, American Finance Association, vol. 32(4), pages 1151-68, September.
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