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Model Disagreement and Economic Outlook

39 Pages Posted: 11 Jun 2014  

Daniel Andrei

University of California, Los Angeles (UCLA) - Anderson School of Management

Bruce I. Carlin

University of California, Los Angeles (UCLA) - Anderson School of Management

Michael Hasler

University of Toronto - Rotman School of Management

Date Written: June 2014

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.

Suggested Citation

Andrei, Daniel and Carlin, Bruce I. and Hasler, Michael, Model Disagreement and Economic Outlook (June 2014). NBER Working Paper No. w20190. Available at SSRN: https://ssrn.com/abstract=2448875

Daniel Andrei (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Bruce I. Carlin

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

Michael Hasler

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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