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Risk Premia, diverse belief and beauty contests

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  • Kurz, Mordecai
  • Motolese, Maurizio

Abstract

We present a theoretical and empirical evaluation of the role of market belief in the structure of risk premia. To that end we employ a familiar asset pricing model for which we develop in detail the belief structure. The novelty in this development is the treatment of individual and market beliefs as Markov state variables. Moreover, the market belief is observable and the paper explains how we extract it from the data. The advantage of our formulation is that it permits a closed form solution of equilibrium prices hence we can trace the exact effect of market belief on the time variability of equilibrium risk premia. We present a model of asset pricing with diverse beliefs. We then explore the conditions under which diverse beliefs arise. We then derive the equilibrium asset pricing and the risk premium which the model implies. Since asset prices are affected by the dynamics of market belief, the component of market risk which is determined by the belief of agents is thus termed “Endogenous Uncertainty.” The theoretical conclusions are tested empirically for investments in the futures markets, the bond markets. Our main theoretical and empirical result is that fluctuations in the market belief about state variables are a dominant factor determining the time variability of risk premia. More specifically, we show that when the market holds abnormally favorable belief about future payoffs of an asset the market views the long position as less risky and hence the risk premium on that asset declines. This means that fluctuations in risk premia are inversely related to the degree of market optimism about future prospects of asset payoffs. This effect is very strong and empirically very dominant. The strong effect of market belief on market risk premia offers two additional perspectives. First, it offers an additional way of showing (for those who have any doubt) that fundamental factors affect market dynamics but perceptions have equally important effect on volatility. Second, that market belief is actually an observable data which can be used for a deeper understanding of the basic causes of stochastic volatility and time variability of risk premia.

Suggested Citation

  • Kurz, Mordecai & Motolese, Maurizio, 2006. "Risk Premia, diverse belief and beauty contests," MPRA Paper 247, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:247
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    File URL: https://mpra.ub.uni-muenchen.de/247/1/MPRA_paper_247.pdf
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    References listed on IDEAS

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    Cited by:

    1. A. A. Brown & L. C. G. Rogers, 2009. "Heterogeneous Beliefs with Finite-Lived Agents," Papers 0907.4953, arXiv.org.
    2. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
    3. Carsten Krabbe Nielsen, 2009. "Rational Overconfidence and Social Security," Discussion Paper Series 0916, Institute of Economic Research, Korea University.
    4. A. A. Brown, 2009. "Heterogeneous Beliefs with Partial Observations," Papers 0907.4950, arXiv.org.
    5. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers 06-045, Stanford Institute for Economic Policy Research.
    6. Nielsen, Carsten Krabbe, 2008. "On rationally confident beliefs and rational overconfidence," Mathematical Social Sciences, Elsevier, vol. 55(3), pages 381-404, May.

    More about this item

    Keywords

    Risk premium; heterogenous beliefs; market state of belief; asset pricing; Bayesian learning; updating beliefs; Rational Beliefs;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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