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Risk Premia, diverse belief and beauty contests

  • Kurz, Mordecai
  • Motolese, Maurizio

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.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 247.

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Date of creation: 19 Sep 2006
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Handle: RePEc:pra:mprapa:247
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  1. Mordecai Kurz & Hehui Jin & Maurizio Motolese, 2005. "Determinants of stock market volatility and risk premia," Annals of Finance, Springer, vol. 1(2), pages 109-147, 07.
  2. Piazzesi, Monika & Swanson, Eric T., 2008. "Futures prices as risk-adjusted forecasts of monetary policy," Journal of Monetary Economics, Elsevier, vol. 55(4), pages 677-691, May.
  3. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
  4. Kurz, Mordecai, 2006. "Beauty contests under private information and diverse beliefs: how different?," MPRA Paper 233, University Library of Munich, Germany, revised Apr 2006.
  5. 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.
  6. Hua He and Jiang Wang., 1993. "Differential Information and Dynamic Behavior of Stock Trading Volume," Research Program in Finance Working Papers RPF-228, University of California at Berkeley.
  7. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980, March.
  8. Stambaugh, Robert F., 1988. "The information in forward rates : Implications for models of the term structure," Journal of Financial Economics, Elsevier, vol. 21(1), pages 41-70, May.
  9. Ho-Mou Wu & Wen-Chung Guo, 2003. "Speculative trading with rational beliefs and endogenous uncertainty," Economic Theory, Springer, vol. 21(2), pages 263-292, 03.
  10. Hodrick, Robert J, 1992. "Dividend Yields and Expected Stock Returns: Alternative Procedures for Inference and Measurement," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 357-86.
  11. Mordecai Kurz & Ho-Mou Wu, . "Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts," Working Papers 96002, Stanford University, Department of Economics.
  12. James H. Stock & Mark W. Watson, 1999. "Forecasting Inflation," NBER Working Papers 7023, National Bureau of Economic Research, Inc.
  13. John Y. Campbell & Robert J. Shiller, 1989. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," NBER Working Papers 3153, National Bureau of Economic Research, Inc.
  14. Carsten Krabbe Nielsen, 1996. "Rational belief structures and rational belief equilibria (*)," Economic Theory, Springer, vol. 8(3), pages 399-422.
  15. James H. Stock & Mark W. Watson, 2001. "Forecasting Output and Inflation: The Role of Asset Prices," NBER Working Papers 8180, National Bureau of Economic Research, Inc.
  16. John H. Cochrane & Monika Piazzesi, 2005. "Bond Risk Premia," American Economic Review, American Economic Association, vol. 95(1), pages 138-160, March.
  17. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July.
  18. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  19. Harris, Milton & Raviv, Artur, 1993. "Differences of Opinion Make a Horse Race," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 473-506.
  20. Maurizio Motolese, 2003. "Endogenous uncertainty and the non-neutrality of money," Economic Theory, Springer, vol. 21(2), pages 317-345, 03.
  21. Mordecai Kurz & Maurizio Motolese, . "Endogenous Uncertainty and Market Volatility," Working Papers 99005, Stanford University, Department of Economics.
  22. Maurizio Motolese, 2001. "Money non-neutrality in a Rational Belief Equilibrium with financial assets," Economic Theory, Springer, vol. 18(1), pages 97-126.
  23. Kurz, Mordecai & Wu, Ho-Mou, 1996. "Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts," Economic Theory, Springer, vol. 8(3), pages 461-88, October.
  24. Min Fan, 2006. "Heterogeneous Beliefs, the Term Structure and Time-varying Risk Premia," Annals of Finance, Springer, vol. 2(3), pages 259-285, July.
  25. Ho-Mou Wu & Mordecai Kurz, 1996. "Endogenous uncertainty in a general equilibrium model with price contingent contracts (*)," Economic Theory, Springer, vol. 8(3), pages 461-488.
  26. Batchelor, Roy & Dua, Pami, 1991. "Blue Chip Rationality Tests," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(4), pages 692-705, November.
  27. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
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