DP6648 Higher Order Expectations in Asset Pricing

Author(s): Philippe Bacchetta , Eric van Wincoop

Publication Date: January 2008

Keyword(s): Asset pricing , Beauty contest , Higher order beliefs

JEL(s): D8 , G0 , G1

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6648.asp.asp

We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. Higher order expectations add an additional term to a standard asset pricing equation. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price. In the context of a dynamic noisy rational expectations model, we show that the higher order wedge depends on first order expectational errors about the mean set of private signals. This in turn depends on expectational errors about future asset payoffs based on errors in public signals. We show that the higher order wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large.