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Higher Order Expectations in Asset Pricing

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  • PHILIPPE BACCHETTA
  • ERIC VAN WINCOOP

Abstract

We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price in the context of a dynamic noisy rational expectations model. We show that the wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large.

Suggested Citation

  • Philippe Bacchetta & Eric Van Wincoop, 2008. "Higher Order Expectations in Asset Pricing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 837-866, August.
    • Handle: RePEc:wly:jmoncb:v:40:y:2008:i:5:p:837-866
    DOI: 10.1111/j.1538-4616.2008.00139.x
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    More about this item

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G0 - Financial Economics - - General
    • G1 - Financial Economics - - General Financial Markets

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