Affective Utilities: A Rational Theory of Optimistic Bias in Asset Markets

13 Pages Posted: 28 Jun 2014

See all articles by Anat Bracha

Anat Bracha

The Hebrew University

Donald Brown

Yale University - Cowles Foundation

Date Written: June 26, 2014

Abstract

The equilibrium prices in asset markets, as stated by Keynes (1930): "...will be fixed at the point at which the sales of the bears and the purchases of the bulls are balanced." We propose a descriptive theory of finance explicating Keynes' claim that the prices of assets today equilibrate the optimism and pessimism of bulls and bears regarding the payoffs of assets tomorrow.

This equilibration of optimistic and pessimistic beliefs of investors is a consequence of investors maximizing affective utilities subject to budget constraints defined by market prices and investor's income. The set of affective utilities is a new class of non-expected utility functions representing the attitudes of investors for optimism or pessimism, defined as the composition of the investor's attitudes for risk and her attitudes for ambiguity. Bulls and bears are defined respectively as optimistic and pessimistic investors.

Keywords: Risk, Ambiguity, Irrational Exuberance

JEL Classification: D81, G02, G11

Suggested Citation

Bracha, Anat and Brown, Donald J., Affective Utilities: A Rational Theory of Optimistic Bias in Asset Markets (June 26, 2014). Cowles Foundation Discussion Paper No. 1898R, Available at SSRN: https://ssrn.com/abstract=2459604

Anat Bracha

The Hebrew University ( email )

Israel

Donald J. Brown (Contact Author)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States

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