The Intertemporal Role of Overconfidence in Competitive Securities Markets
93 Pages Posted: 17 Jun 2003
Date Written: January 2004
This paper explores the role of overconfidence in dynamic competitive securities markets. The existence of a stationary continuous-time noisy quasi-rational expectations equilibrium is shown. It allows to study the intertemporal impact of this psychological bias on securities prices in an imperfect information economy. Thus, this paper tackles the aggregation of diverse information in securities prices which is processed subject to the overconfidence bias. Explicit solutions to an investor's biased dynamic learning problem as well as to the intertemporal consumption and investment problem are provided. Numerically we find that in the presence of overconfidence the risky security's equilibrium price carries a premium in excess of the price which obtains in the rational benchmark economy, the risky security's equilibrium price becomes less sensitive to exogenous supply shocks and the equity risk premium decreases. Due to a deteriorated risk-return trade-off the investors' myopic demand for the risky security decreases but their hedging demand increases. Based on the time-variation of the economy's sentiment the model provides a behavioral explanation for time-varying equity risk premiums.
Keywords: Overconfidence, rational expectations equilibrium, behavioral finance, equity risk premium, filtering problem, imperfect information
JEL Classification: D41, D82, D83, G12
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