Asset Pricing In a World of Imperfect Foresight

Abstract

A key assumption of dynamic asset pricing theory is that agents have perfect foresight: for all future contingencies, they correctly foresee the corresponding equilibrium prices. Is it possible for prices to still reflect perfect foresight even if agents have imperfect foresight? We answer affirmatively, provided agents exhibit a mild form of narrow framing, which we refer to as dynamic narrow framing: while accounting for future endowments, agents ignore re-trading opportunities. This behavior vastly simplifies computations of optimal choices. With a controlled experiment, we verify that our behavioral assumption explains both prices and choices. Our findings allow us to re-interpret the successes and failures of traditional tests of asset pricing theory on historical data from the field.

Keywords: Rational Expectations, Perfect Foresight, Narrow Framing, Dynamic Asset Pricing

JEL Classification: D51, D84, G12, G14