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Model Disagreement and Economic Outlook

Author

Listed:
  • Daniel Andrei
  • Bruce Carlin
  • Michael Hasler

Abstract

We study the impact of model disagreement on the dynamics of asset prices, return volatility, and trade in the market. In our continuous-time framework, two investors have homogeneous preferences and equal access to information, but disagree about the length of the business cycle. We show that model disagreement amplifies return volatility and trading volume by inducing agents to have different economic outlooks, which generates a term structure of disagreement. Different economic outlooks imply that investors will trade even if they do not disagree about the current value of fundamentals. Also, we find that while the absolute level of return volatility is driven by long-run risk, the variation and persistence of volatility (i.e., volatility clustering) is driven by disagreement. Compared to previous studies that consider model uncertainty with a representative agent or those that study heterogeneous beliefs with no model disagreement, our paper offers a theoretical foundation for the GARCH-like behavior of stock returns.

Suggested Citation

  • Daniel Andrei & Bruce Carlin & Michael Hasler, 2014. "Model Disagreement and Economic Outlook," NBER Working Papers 20190, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:20190
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    References listed on IDEAS

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    Cited by:

    1. Remorov, Alexander, 2015. "Dynamic Trading When You May Be Wrong," MPRA Paper 63964, University Library of Munich, Germany, revised 27 Apr 2015.

    More about this item

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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