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Heterogeneous Beliefs and the Cross-Section of Asset Returns

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Abstract

When agents have irrational beliefs which are rational on average, it has been shown that the effect of their trades does not cancel out in general and can lead to time variations in market price of risk and volatility. In this paper, we follow the differences-in-opinion approach and show that the impact of unbiased disagreement on market equilibrium is much stronger in a multi-asset market than in a single-asset market, in which the impact of small disagreement may be negligible. More importantly, we show that different type of disagreement contribute significantly to explain the cross-section of expected returns, volatility and covariance between asset returns. In particular, disagreement can lead to excess volatility, a positive (negative) excess covariance when optimism/pessimism are positively (negatively) correlated between assets and the level of disagreement is negatively (positively) related to expected future returns when the relatively optimistic agent has a larger (smaller) wealth share than the pessimistic agent.

Suggested Citation

  • Xue-Zhong He & Lei Shi, 2012. "Heterogeneous Beliefs and the Cross-Section of Asset Returns," Research Paper Series 303, Quantitative Finance Research Centre, University of Technology, Sydney.
  • Handle: RePEc:uts:rpaper:303
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp303.pdf
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    References listed on IDEAS

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    1. Elyès Jouini & Clotilde Napp, 2007. "Consensus Consumer and Intertemporal Asset Pricing with Heterogeneous Beliefs," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1149-1174.
    2. Harjoat S. Bhamra & Raman Uppal, 2014. "Asset Prices with Heterogeneity in Preferences and Beliefs," Review of Financial Studies, Society for Financial Studies, vol. 27(2), pages 519-580.
    3. Masahiro Watanabe, 2008. "Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry," Journal of Finance, American Finance Association, vol. 63(1), pages 229-272, February.
    4. Xue-Zhong He & Lei Shi, 2012. "Disagreement in a Multi-Asset Market," International Review of Finance, International Review of Finance Ltd., vol. 12(3), pages 357-373, September.
    5. Andrea Buraschi & Alexei Jiltsov, 2006. "Model Uncertainty and Option Markets with Heterogeneous Beliefs," Journal of Finance, American Finance Association, vol. 61(6), pages 2841-2897, December.
    6. Elyès Jouini & Clotilde Napp, 2010. "Unbiased Disagreement in Financial Markets, Waves of Pessimism and the Risk-Return Trade-off," Review of Finance, European Finance Association, vol. 15(3), pages 575-601.
    7. repec:dau:papers:123456789/78 is not listed on IDEAS
    8. Jaksa Cvitanic & Fernando Zapatero, 2004. "Introduction to the Economics and Mathematics of Financial Markets," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262532654, January.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    disagreement; multi-asset market; expected excess returns; excess volatility; excess covariance;

    JEL classification:

    • 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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