Stock and Bond Prices with Disagreement and Habit Formation Preferences

23 Pages Posted: 19 Mar 2011

See all articles by Costas Xiouros

Costas Xiouros

BI Norwegian Business School

Fernando Zapatero

Questrom School of Business, Boston University

Date Written: March 15, 2011

Abstract

We solve analytically a pure exchange general equilibrium model of heterogeneous beliefs with habit forming preferences. Equilibrium prices depend on three factors: (i) the habit formation parameter; ii) the degree of disagreement; iii) the dynamics of disagreement. We show that in the absence of time-varying disagreement, it is possible to construct an observational equivalent economy with homogeneous beliefs, despite the fact that investors update their beliefs in a Bayesian way. We assume time-varying disagreement as a reduced-form model for an economy in which behavioral biases, asymmetric information or cultural differences might explain why information coming to the market is processed differently by different individuals. When the factor of disagreement is time-varying, its time varying properties have significant effects on the interest rate and its volatility. An increase in disagreement increases the interest rate when risk aversion is higher than logarithmic (myopic investor); negative correlation between disagreement and risk aversion (lower disagreement implies higher aggregate risk-aversion), results in lower volatility of interest rates. There is evidence that disagreement and risk aversion are negatively correlated: in recessions risk-aversion goes up while disagreement tends to go down (investors become pessimistic and markets dry up). In addition, time-varying disagreement affects the correlation between stock prices and the discount factor and, therefore, the equity premium.

Keywords: Habit Formation, Disagreement, Heterogeneous Beliefs, Equilibrium

JEL Classification: G12, G14

Suggested Citation

Xiouros, Costas and Zapatero, Fernando, Stock and Bond Prices with Disagreement and Habit Formation Preferences (March 15, 2011). Available at SSRN: https://ssrn.com/abstract=1787371 or http://dx.doi.org/10.2139/ssrn.1787371

Costas Xiouros

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

Fernando Zapatero (Contact Author)

Questrom School of Business, Boston University ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-3631 (Phone)

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