An Approach to Asset Pricing Under Incomplete and Diverse Perceptions

Authors

  • Erik Eyster,

    1. Dept. of Economics, London School of Economics, Houghton Street, London WC2A 2AE, U.K.; e.eyster@lse.ac.uk
    Search for more papers by this author
  • Michele Piccione

    1. Dept. of Economics, London School of Economics, Houghton Street, London WC2A 2AE, U.K.; m.piccione@lse.ac.uk
    Search for more papers by this author
    • We thank the anonymous referees and a co-editor, as well as Ian Jewitt and seminar participants at Berkeley, Bonn, Central European University, Cornell, DIW (Conference on Behavioural Finance), Harvard, Hebrew, Lausanne, Mannheim, Michigan, Northwestern, Penn, Stony Brook (Game Theory Festival), Tel Aviv, and UCL for their helpful comments.


Abstract

We model a dynamic, competitive market, where in every period, risk-neutral traders trade a one-period bond against an infinitely lived asset, with limited short-selling of the long-term asset. Traders lack structural knowledge and use different “incomplete theories,” all of which give statistically correct beliefs about next period's market price of the long-term asset. The more theories there are in the market, the higher is the equilibrium price of the long-term asset. Investors with more complete theories do not necessarily earn higher returns than those with less complete ones, who can earn above the risk-free rate. We provide two necessary conditions for a trader to earn above the risk-free rate.

Ancillary