Heterogeneous Beliefs and the Cross Section of Asset Returns

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.

Number of Pages in PDF File: 29

Keywords: Disagreement, multi-asset market, expected excess returns, excess volatility, excess covariance

JEL Classification: G12, D84

working papers series