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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

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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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  • Franklin Allen & Stephen Morris & Hyun Song Shin, 2003. "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets," Cowles Foundation Discussion Papers 1406, Cowles Foundation for Research in Economics, Yale University.
  • Handle: RePEc:cwl:cwldpp:1406
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    Keywords

    Beauty Contests; Bubbles and iterated expectations in Asset Markets;

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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