The investor recognition hypothesis in a dynamic general equilibrium: Theory and evidence

This dissertation analyzes equilibrium in a dynamic pure-exchange economy under a generalization of Merton's (1987) investor recognition hypothesis (IRH). Because of information costs, a class of investors is assumed to possess incomplete information, which suffices to implement only a particular trading strategy. The IRH is mapped into corresponding portfolio restrictions that bind a subset of agents. The model is formulated in continuous time, and characterization of risk premia, interest rates, and consumption policies of the heterogeneous agents is provided. The model implies that a risk premium on a less visible stock need not be higher than that on a more visible stock with a lower volatility, all else being equal. This contrasts with results previously derived in a static mean-variance setting. An empirical analysis evaluates the IRH based on the premise that the trading strategy of informationally constrained agents is well captured by a combination of two portfolios. The first portfolio represents their (direct) investment in stocks with high visibility. The second portfolio proxies for their exposure (via delegated investment) to stocks with good past-return performance (consistent with documented evidence regarding portfolios of money managers). The findings suggest that a consumption-based capital asset pricing model (CCAPM) augmented by the IRH is a more realistic model than the traditional CCAPM for explaining the cross-sectional variation in unconditional expected equity returns.