Higher Order Expectations in Asset Pricing

40 Pages Posted: 5 Jun 2008

See all articles by Philippe Bacchetta

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Eric van Wincoop

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: January 2008

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 Classification: D8, G0, G1

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, Higher Order Expectations in Asset Pricing (January 2008). CEPR Discussion Paper No. DP6648, Available at SSRN: https://ssrn.com/abstract=1140577

Philippe Bacchetta (Contact Author)

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Eric Van Wincoop

University of Virginia - Department of Economics ( email )

Rouss Hall 114
P.O. Box 400182
Charlottesville, VA 22904-4182
United States
804-924-3997 (Phone)
804-982-2904 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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