Social States of Belief and the Determinants of the Equity Risk Premium in A Rational Belief Equilibrium
September 4, 1997 We review the issues related to the formulation of endogenous uncertainty in rational belief equilibria(RBE). In all previous models of RBE, individual states of belief were the foundation for the construction of the endogenous state space where individual states of belief were described with the method of assessment variables. This approach leads to a lack of "anonymity" where the belief of each individual agent has an impact on equilibrium prices but as a competitor he ignores it. The solution is to study a replica economy with a finite number of types but with a large number of agents of each type. This gives rise to "type-states" which are distributions of beliefs within each type. The state space for this economy is then constructed as the set of products of the exogenous states and the social states of belief which are vectors of distributions of all the types. Such an economy leads to RBE which do indeed solve the problem of anonymity. We then study via simulations the implications of the model of RBE with social states for market volatility and for the determinants of the equity risk premium in an RBE. Under i.i.d. assessments one uses the law of large numbers to induce a single social state of belief and we show that the RBE of such economies have the same number of prices as in rational expectations equilibrium (REE). However, the RBE may exhibit large fluctuations if agents are allowed to hold extreme beliefs. Establishing 5% boundary restrictions on beliefs we show that the model with a single social state of belief cannot explain all the moments of the observed distribution of returns. We then introduce correlation among beliefs and this leads to the creation of new social states. We next show that under correlation among beliefs the model simulations reproduce the values of four key moments of the empirical distribution of returns. The observed equity premium is then explained by two factors. First, investors demand a higher risk premium to compensate them for the endogenous increase in the volatility of returns. Second, at any moment of time there are both rational optimists as well as rational pessimists in our financial markets and such a distribution leads automatically to a decrease in the riskless rate and to an increase of the risk premium. We show that correlation among beliefs of agents leads to fluctuations over time in the social distribution of beliefs and such fluctuations add to endogenous volatility and to a higher equilibrium equity risk premium. JEL Classification Numbers: D58, D84, G12.
|Date of creation:||04 Sep 1997|
|Date of revision:|
|Contact details of provider:|| Postal: Ralph Landau Economics Building, Stanford, CA 94305-6072|
Web page: http://www-econ.stanford.edu/econ/workp/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Weil, Philippe, 1989.
"The equity premium puzzle and the risk-free rate puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 24(3), pages 401-421, November.
- Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
- Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
- Carsten Krabbe Nielsen, 1996.
"Rational belief structures and rational belief equilibria (*),"
Springer, vol. 8(3), pages 399-422.
- Carsten Krabbe Nielsen, 1995. "Rational Belief Structures and Rational Belief Equilibrium," Discussion Papers 95-14, University of Copenhagen. Department of Economics.
- Willaiam A. Brock, 1996. "Asset Price Behavior in Complex Environments," Working Papers 96-04-018, Santa Fe Institute.
- Mehra, Rajnish & Prescott, Edward C., 1985.
"The equity premium: A puzzle,"
Journal of Monetary Economics,
Elsevier, vol. 15(2), pages 145-161, March.
- Follmer, Hans, 1974. "Random economies with many interacting agents," Journal of Mathematical Economics, Elsevier, vol. 1(1), pages 51-62, March.
- Cass, David & Chichilnisky, Graciela & Wu, Ho-Mou, 1996. "Individual Risk and Mutual Insurance," Econometrica, Econometric Society, vol. 64(2), pages 333-41, March.
- Kutz, M. & Schneider, M., 1996.
"Coordination and Correlation in Markov Rational Belief Equilibria,"
281, Banca Italia - Servizio di Studi.
- Mordecai Kurz & Martin Schneider, 1996. "Coordination and correlation in Markov rational belief equilibria (*)," Economic Theory, Springer, vol. 8(3), pages 489-520.
- Abhijit V. Banerjee, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 797-817.
- Mankiw, N. Gregory, 1986.
"The equity premium and the concentration of aggregate shocks,"
Journal of Financial Economics,
Elsevier, vol. 17(1), pages 211-219, September.
- N. Gregory Mankiw, 1986. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
- Henrotte, Philippe, 1996. "Construction of a State Space for Interrelated Securities with an Application to Temporary Equilibrium Theory," Economic Theory, Springer, vol. 8(3), pages 423-59, October.
- Malinvaud, E., 1972. "The allocation of individual risks in large markets," Journal of Economic Theory, Elsevier, vol. 4(2), pages 312-328, April.
- repec:att:wimass:9606 is not listed on IDEAS
- William A. Brock & Steven N. Durlauf, 1995.
"Discrete Choice with Social Interactions I: Theory,"
95-10-084, Santa Fe Institute.
- William A. Brock & Steven N. Durlauf, 1995. "Discrete Choice with Social Interactions I: Theory," NBER Working Papers 5291, National Bureau of Economic Research, Inc.
- Kurz, Mordecai & Wu, Ho-Mou, 1996.
"Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts,"
Springer, vol. 8(3), pages 461-88, October.
- 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.
- Mordecai Kurz & Ho-Mou Wu, . "Endogenous Uncertainty in a General Equilibrium Model with Price Contingent Contracts," Working Papers 96002, Stanford University, Department of Economics.
- Svensson, Lars E O, 1981. "Efficiency and Speculation in a Model with Price-Contingent Contracts," Econometrica, Econometric Society, vol. 49(1), pages 131-51, January.
- Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992.
"A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades,"
Journal of Political Economy,
University of Chicago Press, vol. 100(5), pages 992-1026, October.
- Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 2010. "A theory of Fads, Fashion, Custom and cultural change as informational Cascades," Levine's Working Paper Archive 1193, David K. Levine.
- Brock,W.A. & Durlauf,S.N., 2000. "Discrete choice with social interactions," Working papers 7, Wisconsin Madison - Social Systems.
- Steven N. Durlauf, 1993. "Nonergodic Economic Growth," Review of Economic Studies, Oxford University Press, vol. 60(2), pages 349-366.
- Malinvaud, E, 1973. "Markets for an Exchange Economy with Individual Risks," Econometrica, Econometric Society, vol. 41(3), pages 383-410, May.
- Philippe Henrotte, 1996. "Construction of a state space for interrelated securities with an application to temporary equilibrium theory (*)," Economic Theory, Springer, vol. 8(3), pages 423-459.
- Scharfstein, David S & Stein, Jeremy C, 1990.
"Herd Behavior and Investment,"
American Economic Review,
American Economic Association, vol. 80(3), pages 465-79, June.
- Radner, Roy, 1979. "Rational Expectations Equilibrium: Generic Existence and the Information Revealed by Prices," Econometrica, Econometric Society, vol. 47(3), pages 655-78, May.
- Constantinides, George M, 1990.
"Habit Formation: A Resolution of the Equity Premium Puzzle,"
Journal of Political Economy,
University of Chicago Press, vol. 98(3), pages 519-43, June.
- G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
- William A. Brock, 1993.
"Pathways to randomness in the economy: Emergent nonlinearity and chaos in economics and finance,"
El Colegio de México, Centro de Estudios Económicos, vol. 8(1), pages 3-55.
- W. A. Brock, 1993. "Pathways to Randomness in the Economy: Emergent Nonlinearity and Chaos in Economics and Finance," Working Papers 93-02-006, Santa Fe Institute.
- Brock, William & Lakonishok, Josef & LeBaron, Blake, 1992.
" Simple Technical Trading Rules and the Stochastic Properties of Stock Returns,"
Journal of Finance,
American Finance Association, vol. 47(5), pages 1731-64, December.
- Brock, W. & Lakonishok, J. & Lebaron, B., 1991. "Simple Technical Trading Rules And The Stochastic Properties Of Stock Returns," Working papers 90-22, Wisconsin Madison - Social Systems.
- Radner, Roy, 1972. "Existence of Equilibrium of Plans, Prices, and Price Expectations in a Sequence of Markets," Econometrica, Econometric Society, vol. 40(2), pages 289-303, March.
When requesting a correction, please mention this item's handle: RePEc:wop:stanec:97026. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Thomas Krichel)
If references are entirely missing, you can add them using this form.