Pricing Two Trees When Trees and Investors are Heterogeneous

51 Pages Posted: 1 Mar 2007 Last revised: 26 Mar 2008

See all articles by Nicole Branger

Nicole Branger

University of Muenster - Finance Center Muenster

Christian Schlag

Goethe University Frankfurt - Research Center SAFE

Lue Wu

Goethe University Frankfurt - Department of Finance

Date Written: December 4, 2007

Abstract

We consider an exchange economy with two heterogeneous stocks and two groups of investors. Dividends follow diffusion processes, with a constant expected growth rate for one stock and a stochastic drift for the other. 'Rational investors' can either observe this stochastic drift without error or are at least able to use a noisy signal about it, while 'irrational investors' base their inference only on dividend observations. In an economy with homogeneous investors, uncertainty about the drift increases the volatilities of both stocks and the expected return of the smaller stock. Differences between the two types of stocks are mainly caused by learning, which increases both the volatility and the expected return of the stock with the stochastic drift. When both groups of investor are present, differences in portfolio holdings and thus trading mainly depend on differences in beliefs. In the long run, the irrational investors will be driven out of the market, and for realistic parameter scenarios, they can loose on average half of their wealth within twenty years.

Keywords: Asset Pricing, Two-Tree Economy, Asymmetric Information, Learning, Long-Run Survival

JEL Classification: G11, G12

Suggested Citation

Branger, Nicole and Schlag, Christian and Wu, Lue, Pricing Two Trees When Trees and Investors are Heterogeneous (December 4, 2007). EFA 2007 Ljubljana Meetings Paper. Available at SSRN: https://ssrn.com/abstract=966224 or http://dx.doi.org/10.2139/ssrn.966224

Nicole Branger (Contact Author)

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany
+49 251 83 29779 (Phone)
+49 251 83 22867 (Fax)

HOME PAGE: http://www.wiwi.uni-muenster.de/fcm/fcm/das-finance-center/details.php?weobjectID=162

Christian Schlag

Goethe University Frankfurt - Research Center SAFE ( email )

(http://www.safe-frankfurt.de)
Theodor-W.-Adorno-Platz 3
Frankfurt am Main, 60323
Germany
+49 69 798 33699 (Phone)

Lue Wu

Goethe University Frankfurt - Department of Finance ( email )

Mertonstr. 17-21/Uni-Postbox 77
Frankfurt am Main, 60054
Germany
+49 69 798 28459 (Phone)
+49 69 798 22788 (Fax)

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