COWLES FOUNDATION FOR RESEARCH IN ECONOMICS
AT YALE UNIVERSITY

Box 208281
New Haven, CT 06520-8281

COWLES FOUNDATION DISCUSSION PAPER NO. 1898

(Ir)Rational Exuberance: Optimism, Ambiguity and Risk

Anat Bracha and Donald J. Brown

June 2013

The equilibrium prices in asset markets, as stated by Keynes (1930): "...will be fixed at the point at which the sales of the bears and the purchases of the bulls are balanced." We propose a descriptive theory of finance explicating Keynes' claim that the prices of assets today equilibrate the optimism and pessimism of bulls and bears regarding the payoffs of assets tomorrow.

This equilibration of optimistic and pessimistic beliefs of investors is a consequence of investors maximizing Keynesian utilities subject to budget constraints defined by market prices and investor's income. The set of Keynesian utilities is a new class of non-expected utility functions representing the preferences of investors for optimism or pessimism, defined as the composition of the investor's preferences for risk and her preferences for ambiguity. Bulls and bears are defined respectively as optimistic and pessimistic investors. (Ir)rational exuberance is an intrinsic property of asset markets where bulls and bears are endowed with Keynesian utilities.

JEL Classification: D81, G02, G11

Keywords: Keynes, Bulls and bears, Expectations, Asset markets