Speculative Risk Averse Investor Behavior in a Pure Exchange Economy

We study a pure exchange economy where two classes of infinitely-lived identical isoelastic traders with heterogeneous expectations about state transitions trade a risky asset and a riskless bond. We provide conditions on agents’ preferences and beliefs under which a speculative phenomenon as reported in Harrison and Kreps (1978) arises. No speculation appears when the risk aversion coefficient exceeds unity. Conversely, for a risk aversion coefficient below unity, the equilibrium asset price may exceed even the more optimistic investor’s fundamental valuation provided a fairly equal initial wealth distribution. This phenomenon is exacerbated as investors’ risk aversion shrinks. A high stock price coincides with a low interest rate: difference of opinions leads agents to take opposite leveraged positions. The speculative phenomenon incorporates disagreements in belief in all future contingencies: this explains why even a small initial difference of opinion can generate a large speculative premium, in particular for very patient investors. The case of infinitely risk averse investors, heterogeneous CRRA preferences and Bayesian traders are also examined. JEL Classification: D51, D84, G12