Asset price bubbles from heterogeneous beliefs about mean reversion rates

Research output: Contribution to journalArticle

Abstract

Harrison and Kreps showed in 1978 how the heterogeneity of investor beliefs can drive speculation, leading the price of an asset to exceed its intrinsic value. By focusing on an extremely simple market model-a finite-state Markov chain-the analysis of Harrison and Kreps achieved great clarity but limited realism. Here we achieve similar clarity with greater realism, by considering an asset whose dividend rate is a mean-reverting stochastic process. Our investors agree on the volatility, but have different beliefs about the mean reversion rate. We determine the minimum equilibrium price explicitly; in addition, we characterize it as the unique classical solution of a certain linear differential equation. Our example shows, in a simple and transparent manner, how heterogeneous beliefs about the mean reversion rate can lead to everlasting speculation and a permanent "price bubble."

Original languageEnglish (US)
Pages (from-to)221-241
Number of pages21
JournalFinance and Stochastics
Volume15
Issue number2
DOIs
StatePublished - Jun 2011

Keywords

  • Asset price bubble
  • Heterogeneous beliefs
  • Minimal equilibrium price

ASJC Scopus subject areas

  • Statistics and Probability
  • Finance
  • Statistics, Probability and Uncertainty

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