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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

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 and explain over-reaction to (noisy) public information.

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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1406.

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Length: 37 pages
Date of creation: Mar 2003
Date of revision:
Publication status: Published in Review of Financial Studies (2006), 19: 719-752
Handle: RePEc:cwl:cwldpp:1406
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  10. Franklin Allen & Stephen Morris & Andrew Postlewaite, . "Finite Bubbles with Short Sale Constraints and Asymmetric Information (Reprint 042)," Rodney L. White Center for Financial Research Working Papers 16-92, Wharton School Rodney L. White Center for Financial Research.
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  18. Samet, Dov, 1998. "Iterated Expectations and Common Priors," Games and Economic Behavior, Elsevier, vol. 24(1-2), pages 131-141, July.
  19. Christian Hellwig, 2002. "Public Announcements, Adjustment Delays, and the Business Cycle (November 2002)," UCLA Economics Online Papers 208, UCLA Department of Economics.
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  24. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February.
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