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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

Author

Listed:
  • Stephen Morris

    (Yale University, Cowles Foundation)

  • Franklin Allen

    (University of Pennsylvania, The Wharton School, Finance Department)

  • Hyun Song Shin

    (University of London, London School of Economics & Political Science (LSE), Department of Accounting and Finance)

Abstract

In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information.

Suggested Citation

  • Stephen Morris & Franklin Allen & Hyun Song Shin, 2004. "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets," Yale School of Management Working Papers ysm346, Yale School of Management.
    • Handle: RePEc:ysm:somwrk:ysm346
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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