Publication Date: March 2003
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.
Beauty contests, Bubbles, Noisy rational expectations equilibrium, Martingales, Public information, Asset prices
JEL Classification Codes: E4, G12
Published in Review of Financial Studies (Fall 2006), 19(3): 719-752 [DOI]