Aggregation of Heterogeneous Beliefs and Asset Pricing Theory: A Mean-Variance Analysis
Quantitative Finance Research Centre Working Paper No. 186
23 Pages Posted: 17 Mar 2008
Date Written: October 2006
Within the standard mean-variance framework, this paper provides a procedure to aggregate the heterogeneous beliefs in not only risk preferences and expected payoffs but also variances/covariances into a market consensus belief. Consequently, an asset equilibrium price under heterogeneous beliefs is derived. We show that the market aggregate behavior is in principle a weighted average of heterogeneous individual behaviors. The CAPM-like equilibrium price and return relationships under heterogeneous beliefs are obtained. The impact of diversity of heterogeneous beliefs on the market aggregate risk preference, asset volatility, equilibrium price and optimal demands of investors is examined. As a special case, our result provides a simple explanation for the empirical relation between cross-sectional volatility and expected returns.
JEL Classification: G12, D84
Suggested Citation: Suggested Citation