Risk Premiums, Liquidities, and Bubbles under Heterogeneous Beliefs

Abstract

We develop a model in which investors have heterogeneous beliefs about both the mean and the risk of future signals and the final stock payoff. As investors who perceive the lowest risk vary across different periods, the overall perception of the market risk is reduced in an economy with dynamic trading, always reducing risk premium and increasing market liquidity. Bubbles can arise without the short-sales constraint. We show that the more frequently investors trade in the future, the more liquid the market today, which provides potential explanations for a number of empirical findings.

Keywords: Heterogeneous beliefs; Risk premiums; Liquidities; Bubbles

JEL Classification: G10; G12; G14