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Diverse beliefs and time variability of risk premia

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  • Mordecai Kurz

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  • Maurizio Motolese

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Abstract

This work presents a theoretical and empirical evaluation of the role of market belief in the structure of risk premia. Our main result is that fluctuations in market belief are large contributors to the time variability of risk premia. On average, the risk premium on holding Federal Funds Futures and 3-month and 6-month Treasury Bills for 6-12 months is about 40-60 basis points. We show that over 50% of the time market beliefs contribute more than 25-30 basis points to the premium. Moreover, the time variability of market belief is so large that this contribution is frequently larger than 50 basis points. As to the structure of the premium we show that when the market holds abnormally favorable belief about an asset’s future payoffs the market views the long position as less risky and hence the risk premium on that asset declines. Generalizing to the market as a whole we show that periods of market optimism (i.e. bull markets) are periods when the market risk assessment falls while in periods of pessimism the market’s risk assessment rises. That is, fluctuations in risk premia are inversely related to the degree of market optimism about future prospects of asset payoffs.
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  • Mordecai Kurz & Maurizio Motolese, 2011. "Diverse beliefs and time variability of risk premia," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 293-335, June.
  • Handle: RePEc:spr:joecth:v:47:y:2011:i:2:p:293-335
    DOI: 10.1007/s00199-010-0550-1
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    Cited by:

    1. Mordecai Kurz & Maurizio Motolese & Giulia Piccillo & Howei Wu, 2015. "Monetary Policy with Diverse Private Expectations," Discussion Papers 15-004, Stanford Institute for Economic Policy Research.
    2. William Branch & George Evans, 2011. "Monetary policy and heterogeneous expectations," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 365-393, June.
    3. F. Verona & M. M. F. Martins & I. Drumond, 2013. "(Un)anticipated Monetary Policy in a DSGE Model with a Shadow Banking System," International Journal of Central Banking, International Journal of Central Banking, vol. 9(3), pages 78-124, September.
    4. Bell, Peter N, 2013. "New Testing Procedures to Assess Market Efficiency with Trading Rules," MPRA Paper 46701, University Library of Munich, Germany.
    5. Johanna Etner & Meglena Jeleva, 2014. "Underestimation of probabilities modifications: characterization and economic implications," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 56(2), pages 291-307, June.
    6. Wen-Chung Guo & Frank Wang & Ho-Mou Wu, 2011. "Financial leverage and market volatility with diverse beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 337-364, June.
    7. repec:spr:joecth:v:64:y:2017:i:1:d:10.1007_s00199-016-0980-5 is not listed on IDEAS
    8. Carsten Nielsen, 2011. "Price stabilizing, Pareto improving policies," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 459-500, June.
    9. Roberto Motto & Massimo Rostagno & Lawrence J. Christiano, 2010. "Financial Factors in Economic Fluctuations," 2010 Meeting Papers 141, Society for Economic Dynamics.
    10. Söderlind, Paul, 2009. "Why disagreement may not matter (much) for asset prices," Finance Research Letters, Elsevier, vol. 6(2), pages 73-82, June.
    11. Kurz, Mordecai & Piccillo, Giulia & Wu, Howei, 2013. "Modeling diverse expectations in an aggregated New Keynesian Model," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1403-1433.
    12. William Branch & Bruce McGough, 2011. "Business cycle amplification with heterogeneous expectations," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 395-421, June.
    13. Hiroyuki Nakata, 2013. "Welfare effects of short-sale constraints under heterogeneous beliefs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 53(2), pages 283-314, June.
    14. Volha Audzei, 2012. "Efficiency of Central Bank Policy During the Crisis : Role of Expectations in Reinforcing Hoarding Behavior," CERGE-EI Working Papers wp477, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    15. Carsten Krabbe Nielsen, 2009. "Rational Overconfidence and Social Security," Discussion Paper Series 0916, Institute of Economic Research, Korea University.
    16. Paul De Grauwe, 2012. "Lectures on Behavioral Macroeconomics," Economics Books, Princeton University Press, edition 1, number 9891.
    17. Roger Guesnerie & Pedro Jara-Moroni, 2011. "Expectational coordination in simple economic contexts," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 205-246, June.
    18. Nandini Srivastava & Stephen Satchell, 2012. "Are There Bubbles in the Art Market? The Detection of Bubbles when Fair Value is Unobservable," Birkbeck Working Papers in Economics and Finance 1209, Birkbeck, Department of Economics, Mathematics & Statistics.
    19. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 189-204, June.
    20. Michael Woodford, 2013. "Macroeconomic Analysis Without the Rational Expectations Hypothesis," Annual Review of Economics, Annual Reviews, vol. 5(1), pages 303-346, May.
    21. Eugene Amromin & Steven A. Sharpe, 2012. "From the horse’s mouth: how do investor expectations of risk and return vary with economic conditions?," Working Paper Series WP-2012-08, Federal Reserve Bank of Chicago.
    22. Rieger, Jörg, 2014. "Financial Transaction Tax and Financial Market Stability with Diverse Beliefs," Working Papers 0563, University of Heidelberg, Department of Economics.
    23. Volker Wieland & Maik Wolters, 2011. "The diversity of forecasts from macroeconomic models of the US economy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 247-292, June.
    24. Paul Grauwe, 2011. "Animal spirits and monetary policy," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 47(2), pages 423-457, June.
    25. Maurizio MOTOLESE & NAKATA Hiroyuki, 2016. "Endogenous Fluctuations and Social Welfare under Credit Constraints and Heterogeneous Beliefs," Discussion papers 16082, Research Institute of Economy, Trade and Industry (RIETI).

    More about this item

    Keywords

    Risk premium; Market belief; Perception models; Empirical distribution; Asset pricing; C53; D8; D84; E27; E4; G12; G14;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • E27 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Forecasting and Simulation: Models and Applications

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