COWLES FOUNDATION FOR RESEARCH IN
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COWLES FOUNDATION DISCUSSION PAPER NO. 1406 Beauty Contests, Bubbles and Iterated Expectations in Asset Markets Franklin Allen, Stephen Morris and Hyun Song Shin March 2003 In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information. JEL Classification: E4, G12 Keywords: Beauty contests, Bubbles, Noisy rational expectations equilibrium, Martingales, Public information, Asset prices |
