Affective Utilities: A Rational Theory of Optimistic Bias in Asset Markets
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The equilibrium prices in asset markets, as stated by Keynes (1930): “…will be ﬁxed at the point at which the sales of the bears and the purchases of the bulls are balanced.” We propose a descriptive theory of ﬁnance explicating Keynes’ claim that the prices of assets today equilibrate the optimism and pessimism of bulls and bears regarding the payoﬀs of assets tomorrow. This equilibration of optimistic and pessimistic beliefs of investors is a consequence of investors maximizing aﬀective utilities subject to budget constraints deﬁned by market prices and investor’s income. The set of aﬀective utilities is a new class of non-expected utility functions representing the attitudes of investors for optimism or pessimism, deﬁned as the composition of the investor’s attitudes for risk and her attitudes for ambiguity. Bulls and bears are deﬁned respectively as optimistic and pessimistic investors.
Bracha, Anat and Brown, Donald J., "Affective Utilities: A Rational Theory of Optimistic Bias in Asset Markets" (2013). Cowles Foundation Discussion Papers. 2280.