Differences in Opinion and Risk Premium

When people agree to disagree, this paper examines the impact of the disagreement among agents on market equilibrium and equity premium. Within the standard mean variance framework, we consider a market of two risky assets, a riskless asset and two (and then a continuum of) agents who have different preferences and heterogeneous beliefs in the means and variance/covariances of the asset returns. By constructing a consensus belief, we introduce a boundedly rational equilibrium (BRE) to characterize the market equilibrium and derive a CAPM under heterogeneous beliefs. When the differences in opinion are formed as mean-preserving spreads of a benchmark homogeneous belief, we analyz eexplicitly the impact on the market equilibrium and risk premium, showing that the risk tolerance, optimism/pessimism and con?dence/doubt can jointly generate high risk premium and low risk-free rate. JELClassi?cation:.