Boundedly rational equilibrium and risk premium

Authors


  • Financial supports from the Australian Research Council (ARC) under Discovery Grant (DP0773776) and a Faculty Research Grant at UTS are gratefully acknowledged.

Abstract

When people agree to disagree, the impact of the disagreement among agents on the market is the main concern of this paper. With the standard mean variance framework, this paper considers a market of two risky assets and two agents who have different preference and disagreement about the mean and variance/covariance of the asset returns. By constructing a consensus belief, the paper develops an concept of boundedly rational equilibrium (BRE) to characterize the market equilibrium and examines explicitly the impact of heterogeneity on the market equilibrium and risk premium when the disagreements among the two agents are mean preserved spreads of a benchmark homogeneous belief. It shows that, in market equilibrium, the biased mean preserved spreads in beliefs among the two agents have significant impact on the risk premium of the risky assets and market portfolio, and adding a riskless asset in the market magnifies the impact of the heterogeneity on the market. The results show that both optimism/pessemism and confidence/doubt can increase the market risk premium and reduce the riskfree rate.

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