Working Paper: CEPR ID: DP6648
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. Higher order expectations add an additional term to a standard asset pricing equation. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price. In the context of a dynamic noisy rational expectations model, we show that the higher order wedge depends on first order expectational errors about the mean set of private signals. This in turn depends on expectational errors about future asset payoffs based on errors in public signals. We show that the higher order wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large.
Keywords: Asset Pricing; Beauty Contest; Higher Order Beliefs
JEL Codes: D8; G0; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher order wedge (C69) | equilibrium price (D41) |
| higher order expectations (D84) | higher order wedge (C69) |
| first order expectational errors (C51) | higher order wedge (C69) |
| public signals (C11) | first order expectational errors (C51) |
| higher order wedge (C69) | asset price volatility (G19) |
| higher order wedge (C69) | present value of future payoffs (J17) |
| expectational errors about future payoffs (D84) | portfolio holdings (G11) |
| portfolio holdings (G11) | asset prices (G19) |