Incomplete Information, Heterogeneity, and Asset Pricing

Book excerpt: We consider a pure exchange economy where the drift of aggregate consumption is unobservable. Agents with heterogeneous beliefs and preferences act competitively on financial and goods 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 propose a number of specifications of risk aversions and beliefs where the market price of risk is much higher, and the riskless rate of return lower, than in the equivalent full information economy (homogeneous and heterogeneous preferences) and thus can provide an(other) answer to the equity premium and risk-free rate puzzles. We also derive a representation of the equilibrium volatility and numerically assess the role of heterogeneity in beliefs. We show that a high level of stock volatility can be obtained with a low level of aggregate consumption volatility when beliefs are heterogeneous. Finally, we discuss how incomplete information may explain the apparent predictability in stock returns and show that in-sample predictability cannot be exploited by the agents, as it is in fact a result of their learning processes.