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Beauty Contests and Iterated Expectations in Asset Markets

  • Franklin Allen
  • Stephen Morris
  • Hyun Song Shin

In a financial market where traders are risk averse and short lived and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not, in general, equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher-order beliefs in a fully rational asset pricing model. Copyright 2006, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhj036
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Article provided by Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 19 (2006)
Issue (Month): 3 ()
Pages: 719-752

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Handle: RePEc:oup:rfinst:v:19:y:2006:i:3:p:719-752
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