Model Disagreement and Economic Outlook / Daniel Andrei, Bruce Carlin, Michael Hasler.

Format:

Book

Author/Creator:

Andrei, Daniel.

Contributor:

National Bureau of Economic Research.

Carlin, Bruce.

Hasler, Michael.

Series:

Working Paper Series (National Bureau of Economic Research) no. w20190.

NBER working paper series no. w20190

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2014.

Summary:

We study the impact of model disagreement on the dynamics of asset prices, return volatility, and trade in the market. In our continuous-time framework, two investors have homogeneous preferences and equal access to information, but disagree about the length of the business cycle. We show that model disagreement amplifies return volatility and trading volume by inducing agents to have different economic outlooks, which generates a term structure of disagreement. Different economic outlooks imply that investors will trade even if they do not disagree about the current value of fundamentals. Also, we find that while the absolute level of return volatility is driven by long-run risk, the variation and persistence of volatility (i.e., volatility clustering) is driven by disagreement. Compared to previous studies that consider model uncertainty with a representative agent or those that study heterogeneous beliefs with no model disagreement, our paper offers a theoretical foundation for the GARCH-like behavior of stock returns.

Notes:

Print version record

June 2014.