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Segmentation and beliefs: A theory of self-fulfilling idiosyncratic risk

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  • Khorrami, Paymon
  • Zentefis, Alexander K.

Abstract

We study a multi-location general equilibrium model with financial market segmentation that permits self-fulfilling fluctuations. In a precise sense, such fluctuations are most often redistributive, but their volatility varies systematically with an aggregate latent factor. We thus provide a coordination-based microfoundation for time-varying idiosyncratic risk. A key assumption of our analysis is that cash flow growth rates (e.g., firm profit growth, asset dividend growth, or country output growth) rise with valuations. We consider two applications: (i) firm dynamics and their risk factor structure; and (ii) exchange rate disconnect in international macroeconomics.

Suggested Citation

  • Khorrami, Paymon & Zentefis, Alexander K., 2025. "Segmentation and beliefs: A theory of self-fulfilling idiosyncratic risk," Journal of Economic Theory, Elsevier, vol. 223(C).
    • Handle: RePEc:eee:jetheo:v:223:y:2025:i:c:s0022053124001601
    DOI: 10.1016/j.jet.2024.105954
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    More about this item

    Keywords

    Idiosyncratic risk; Segmented markets; Volatility; Asset pricing; Multiple equilibria;
    All these keywords.

    JEL classification:

    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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