Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth?

40 Pages Posted: 29 Jun 2005

See all articles by Filippo Taddei

Filippo Taddei

School of Advanced International Studies (SAIS) - The Johns Hopkins University

Date Written: November 20, 2003

Abstract

Abandoning the representative agent framework to introduce heterogeneity of beliefs across different agents allows us to build a link between wealth distribution and the equity premium. We demonstrate that an economy populated only by risk neutral agents may nonetheless display a strictly positive equity premium. Moreover, belief heterogeneity provides a possible explanation of the temporal evolution of the premium.

We then place our notion of beliefs heterogeneity within the popular representative agent construct and argue that, given any level of belief heterogeneity, equilibrium prices in a multi agent economy can be replicated in a representative agent economy assuming a particular degree of risk aversion. A fully dynamic model of consumption based asset pricing with belief heterogeneity follows.

Finally, we suggest an explanation for the market behavior of the equity premium in the last decade: a story of heterogeneous optimism versus homogeneous pessimism is presented.

Keywords: Belief heterogeneity, equity premium puzzle, representative agent, risk aversion, wealth distribution

JEL Classification: D31, D84, G12

Suggested Citation

Taddei, Filippo, Equity Premium: Interaction of Belief Heterogeneity and Distribution of Wealth? (November 20, 2003). Available at SSRN: https://ssrn.com/abstract=752965 or http://dx.doi.org/10.2139/ssrn.752965

Filippo Taddei (Contact Author)

School of Advanced International Studies (SAIS) - The Johns Hopkins University ( email )

via Andreatta, 3
Bologna, Bologna
Italy

HOME PAGE: http://https://www.sais-jhu.edu/filippo-taddei

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