Heterogeneous Expectations, Asset Prices, and Trading Volume under a Non-expected Utility Function with CARA
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Using a non-expected utility function that exhibits constant relative risk aversion (CRRA), Cho (2001) explores a theoretical model of asset pricing under heterogeneous beliefs in the case where only one risky asset is traded. This paper extends his work into the case where agents trade a risky asset and the riskless asset as well, adopting a non-expected utility function that exhibits constant absolute risk aversion (CARA). In a variant of the general equilibrium setting of Lucas (1978), major findings of the paper are as follows: (i) When agents differ only in expectations about future dividends, the question of who is the buyer and who is the seller of each asset depends solely on the degree of optimism. Unlike the case of Cho (2001), there is no role of intertemporal substitution. (ii) Increased dispersion of expectations will raise the risk-free rate and lower the risky asset’s price. This result is consistent with that of Abel (1990). (iii) Although the equity premium goes up as a consequence of result (ii), heterogeneity per se does not help to resolve the puzzle posed by Mehra & Prescott (1985) and Weil (1989). (iv) The trading volume of the risky asset increases proportionately with the cross-sectional variance of expectations, and the same is true for the riskless asset. (iv) An increase in the risk-free interest rate will reduce the trading volume of the riskless asset unless the intertemporal substitution parameter is less than 1/2. In addition to these findings, many more comparative statics results are obtained from closed-form solutions for asset prices and trading volume.
Abstract
Using a non-expected utility function that exhibits constant relative risk aversion (CRRA), Cho (2001) explores a theoretical model of asset pricing under heterogeneous beliefs in the case where only one risky asset is traded. This paper extends his work into the case where agents trade a risky asset and the riskless asset as well, adopting a non-expected utility function that exhibits constant absolute risk aversion (CARA). In a variant of the general equilibrium setting of Lucas (1978), major findings of the paper are as follows: (i) When agents differ only in expectations about future dividends, the question of who is the buyer and who is the seller of each asset depends solely on the degree of optimism. Unlike the case of Cho (2001), there is no role of intertemporal substitution. (ii) Increased dispersion of expectations will raise the risk-free rate and lower the risky asset’s price. This result is consistent with that of Abel (1990). (iii) Although the equity premium goes up as a consequence of result (ii), heterogeneity per se does not help to resolve the puzzle posed by Mehra & Prescott (1985) and Weil (1989). (iv) The trading volume of the risky asset increases proportionately with the cross-sectional variance of expectations, and the same is true for the riskless asset. (iv) An increase in the risk-free interest rate will reduce the trading volume of the riskless asset unless the intertemporal substitution parameter is less than 1/2. In addition to these findings, many more comparative statics results are obtained from closed-form solutions for asset prices and trading volume.
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