Aggregation of Heterogeneous Beliefs and Asset Pricing Theory: A Mean-Variance Analysis

Carl Chiarella (), Roberto Dieci and Xuezhong He ()
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Roberto Dieci: Dipartimento di Matematica per le Scienze Economiche e Sociali, University of Bologna

No 186, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Within the standard mean-variance framework, this paper provides a procedure to aggregate the heterogeneous beliefs in not only risk preferences and expected payoffs but also variances/covariances into a market consensus belief. Consequently, an asset equilibrium price under heterogeneous beliefs is derived. We show that the market aggregate behavior is in principle a weighted average of heterogeneous individual behaviors. The CAPM-like equilibrium price and return relationships under heterogeneous beliefs are obtained. The impact of diversity of heterogeneous beliefs on the market aggregate risk preference, asset volatility, equilibrium price and optimal demands of investors is examined. As a special case, our result provides a simple explanation for the empirical relation between cross-sectional volatility and expected returns.

JEL-codes: G12 D84 (search for similar items in EconPapers)
Date: 2006-10-01
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