Incomplete Information, Heterogeneity and Asset Pricing

Abstract

We consider a pure exchange economy where the drift of aggregate consumption is unobservable. Agents with heterogeneous beliefs and preferences act competitively on a financial and good markets. We discuss how equilibrium market prices of risk differ across agents, and in particular we discuss the properties of the market price of risk under the physical (objective) probability measure. We provide a number of specification of risk aversions and beliefs where the market price of risk is much higher than in the equivalent full information economy (homogeneous and heterogeneous preferences) and thus could provide an(other) answer to the equity premium puzzle. We also provide a representation of the equilibrium volatility and numerically assess the role of heterogeneity. We show that high level of stock volatility can be obtained with low level of aggregate consumption volatility when beliefs are heterogeneous. Finally we discuss how heterogeneity may explain the apparent predictability in stock return, and show that in-sample predictability can not be exploited by the agents, as it is in fact a result of their learning process.

Keywords: Asset Pricing

JEL Classification: G12