Asset Pricing With Heterogenous Beliefs in a Two Trees Setting

This paper studies the stock price formation in a pure-exchange economy populated by investors who disagree on the expected dividend growth rates. The homogenous beliefs equilibrium model of Cochrane, Longstaff, and Santa-Clara (2005) is extended to allow for belief heterogeneity, and the equilibrium is characterized. Stock prices and the volatility structure is expressed as conditional expectations, which can be solved numerically with Monte-Carlo simulations. The equilibrium is solved for in three stylized examples. First, confidence in the numerical scheme is obtained by replicating the results of Cochrane et al. (2005). Then, parameter uncertainty (but homogenous beliefs) is introduced and is found to decrease (increase) expected rates of return of the asset that constitutes less (more) of the market portfolio. Return volatilities increase and return correlation decreases as a consequence of parameter uncertainty. Finally, belief heterogeneity is found to complicate the economy even further, the effect being most profound for the return volatility and correlation structures