A Model of Dynamic Equilibrium Asset Pricing with Extraneous Risk

Wharton Working Paper No. 2-97

Posted: 30 Apr 1997

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Abstract

We study dynamic equilibrium behavior of security prices in an economy where non-fundamental risk arises from agents' heterogeneous beliefs about extraneous processes. We provide a complete characterization of equilibrium in terms of the primitives of the economy, via construction of a representative agent with stochastic weights. Besides the standard pricing of fundamental risk, an agent now also prices the non-fundamental risk with a market price which is a risk-tolerance weighted average of his extraneous disagreement with all remaining agents. Consequently, for given risk tolerances, agents' perceived state prices and consumption streams are more volatile in the presence of extraneous risk. The interest rate inherits additional terms arising from agents' misperceptions about consumption growth, and from precautionary savings motives against the non-fundamental uncertainty.

JEL Classification: D51, G12

Suggested Citation

Basak, Suleyman, A Model of Dynamic Equilibrium Asset Pricing with Extraneous Risk. Wharton Working Paper No. 2-97. Available at SSRN: https://ssrn.com/abstract=8321

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Centre for Economic Policy Research (CEPR)

London
United Kingdom

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