Model Disagreement, Volatility, and Trading Volume∗

We study the impact of model disagreement on the dynamics of asset prices, return volatility, and trade in the market. In our continuous-time framework, two investors have homogenous preferences and equal access to information, but disagree about the length of the business cycle. We show that while the absolute level of volatility is driven primarily by long-run risk, the variation and persistence of volatility (i.e., volatility clustering) is driven by disagreement. Not only can disagreement amplify volatility in the market, but it is also the primary channel through which volatility affects trading volume. Compared to previous studies that consider model uncertainty with a representative agent or those which study heterogeneous beliefs with no model disagreement, our paper helps us to understand the evolution of the persistent, time-varying volatility process that we observe empirically. ∗We would like to thank Tony Berrada, Mike Chernov, Julien Cujean, Jerome Detemple, Bernard Dumas, Julien Hugonnier, Arvind Krishnamurthy, Francis Longstaff, and Pascal St.-Amour for their useful advice. We would also like to acknowledge comments from participands at the SFI finance seminar in Gerzensee 2010 and the 4th International Forum on Long-Term Risks in Paris 2011. Financial support from the Swiss Finance Institute, NCCR FINRISK of the Swiss National Science Foundation, UCLA, and the University of Toronto is gratefully acknowledged. †UCLA, Anderson School of Management, 110 Westwood Plaza, Suite C420, Los Angeles, CA 90095, USA, [email protected], www.danielandrei.net ‡UCLA, Anderson School of Management, 110 Westwood Plaza, Suite C413, Los Angeles, CA 90095, USA, [email protected], http://www.anderson.ucla.edu/faculty/finance/faculty/carlin §University of Toronto, Rotman School of Management, 105 St. George Street, Toronto, ON, M5S 3E6, Canada, [email protected], www.rotman.utoronto.ca/Faculty/Hasler.aspx