Beauty Contests and Iterated Expectations in Asset Markets

Authors: Allen, Franklin; Morris, Stephen; Shin, Hyun Song

Source: Review of Financial Studies, Volume 19, Number 3, 1 2006 , pp. 719-752(34)

Publisher: Oxford University Press

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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.

Document Type: Research article

DOI: 10.1093/rfs/hhj036

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