Heterogeneous Beliefs, Speculation, and the Equity Premium



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    • Alexander David is at the Haskayne School of Business, University of Calgary. I thank an anonymous referee, an associate editor, Rob Stambaugh (the Editor), Suleyman Basak, Brian Boyer (EFA Discussant), Michael Brennan, Benjamin Croitoru (FEA Discussant), Kent Daniel, Darrell Duffie, Bob Goldstein, John Heaton, Joe Ostroy, Anna Pavlova, Chris Telmer (AFA Discussant), Pietro Veronesi, Luis Viceira, Harold Zhang (FRB Conference Discussant), and especially Phil Dybvig, as well as seminar participants at Washington University in St. Louis, London Business School, Lancaster University, University of Calgary, University of South Carolina, University of Central Florida, Federal Reserve Bank of St. Louis, Brigham Young University, the 2004 Annual Derivatives Securities Conference, Third World Congress of the Bachelier Finance Society, the 2004 European Finance Association, the 2004 Annual Conference on Financial Economics and Accounting, the 2005 Conference on Risk Premiums at the Federal Reserve Board, and the 2005 American Finance Association for helpful comments. I gratefully acknowledge a research grant from the SSHRC. Appendices C and D are available at: http://homepages.ucalgary.ca/~adavid.


Agents with heterogeneous beliefs about fundamental growth do not share risks perfectly but instead speculate with each other on the relative accuracy of their models' predictions. They face the risk that market prices move more in line with the trading models of competing agents than with their own. Less risk-averse agents speculate more aggressively and demand higher risk premiums. My calibrated model generates countercyclical consumption volatility, earnings forecast dispersion, and cross-sectional consumption dispersion. With a risk aversion coefficient less than one, agents' speculation causes half the observed equity premium and lowers the riskless rate by about 1%.