Document Type
Discussion Paper
Publication Date
3-1-2003
CFDP Number
1406
CFDP Pages
37
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.
Recommended Citation
Allen, Franklin; Morris, Stephen; and Shin, Hyun Song, "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets" (2003). Cowles Foundation Discussion Papers. 1674.
https://elischolar.library.yale.edu/cowles-discussion-paper-series/1674