Higher Order Expectations in Asset Pricing

We examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. We call this the higher order wedge, which depends on the difference between higher and first order expectations of future payoffs. We analyze the determinants of this wedge and its impact on the equilibrium price in the context of a dynamic noisy rational expectations model. We show that the wedge reduces asset price volatility and disconnects the price from the present value of future payoffs. The impact of the higher order wedge on the equilibrium price can be quantitatively large. Copyright (c) 2008 The Ohio State University.