Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

38 Pages Posted: 8 Mar 2003

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Stephen Morris

MIT

Hyun Song Shin

Bank for International Settlements (BIS)

Date Written: March 2003

Abstract

In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information.

Keywords: Beauty Contests, Bubbles, Noisy Rational Expectations Equilibrium, Martingales, Public Information, Asset Prices

JEL Classification: E4, G12

Suggested Citation

Allen, Franklin and Morris, Stephen Edward and Shin, Hyun Song, Beauty Contests, Bubbles and Iterated Expectations in Asset Markets (March 2003). Cowles Foundation Discussion Paper No. 1406; AFA 2004 San Diego Meetings. Available at SSRN: https://ssrn.com/abstract=386083

Franklin Allen

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Stephen Edward Morris (Contact Author)

MIT ( email )

77 Massachusetts Avenue
50 Memorial Drive
Cambridge, MA 02139-4307
United States

HOME PAGE: http://https://economics.mit.edu/faculty/semorris

Hyun Song Shin

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

HOME PAGE: http://www.bis.org/author/hyun_song_shin.htm

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