Working Paper: NBER ID: w20190
Authors: Daniel Andrei; Bruce Carlin; Michael Hasler
Abstract: We study the impact of model disagreement on the dynamics of asset prices, return volatility, and trade in the market. In our continuous-time framework, two investors have homogeneous preferences and equal access to information, but disagree about the length of the business cycle. We show that model disagreement amplifies return volatility and trading volume by inducing agents to have different economic outlooks, which generates a term structure of disagreement. Different economic outlooks imply that investors will trade even if they do not disagree about the current value of fundamentals. Also, we find that while the absolute level of return volatility is driven by long-run risk, the variation and persistence of volatility (i.e., volatility clustering) is driven by disagreement. Compared to previous studies that consider model uncertainty with a representative agent or those that study heterogeneous beliefs with no model disagreement, our paper offers a theoretical foundation for the GARCH-like behavior of stock returns.
Keywords: model disagreement; asset prices; return volatility; trading volume
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| model disagreement (C52) | return volatility (G17) |
| model disagreement (C52) | trading volume (G15) |
| different economic outlooks (E66) | return volatility (G17) |
| different economic outlooks (E66) | trading volume (G15) |
| disagreement over fundamentals (D74) | asset price dynamics (G19) |
| long-run risk (G19) | absolute level of return volatility (G17) |
| model disagreement (C52) | volatility clustering (C58) |
| persistent disagreement (D74) | excess volatility (G17) |