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Beauty Contests, Bubbles and Iterated Expectations in Asset Markets

Stephen Morris, Franklin Allen and Hyun Song Shin

Yale School of Management Working Papers from Yale School of Management

Abstract: In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information.

Keywords: Beauty Contests; Bubbles; Noisy Rational Expectations Equilibrium; Martingales; Public Information; Asset Prices (search for similar items in EconPapers)
JEL-codes: E4 G12 (search for similar items in EconPapers)
Date: 2004-07-28
New Economics Papers: this item is included in nep-cfn, nep-fin, nep-fmk and nep-mac
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Citations: View citations in EconPapers (23)

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Working Paper: Beauty Contests, Bubbles and Iterated Expectations in Asset Markets (2003) Downloads
Working Paper: Beauty Contests, Bubbles and Iterated Expectations in Asset Markets (2003) Downloads
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