Heterogeneous Prior Beliefs and Asset Pricing with Expected Gain from Active Trading

Asset pricing formulas generated from representative agent models help in computing the fundamental values of assets that investors plan to hold forever. In contrast, in an economy with heterogeneous agents and active trading, stock prices will persistently deviate from the expected fundamental value even without introducing any explosive bubbles. Particularly, the introduction of heterogeneous prior beliefs leads to an additional non-trivial expected gain from active trading (EGFAT) in the new asset pricing formula, since the law of iterated expectations fails to apply to a market where the beliefs of marginal investors determine the trading prices. Provided informational frictions, the new framework suggests that speculative manipulations may be profitable in stock markets imposing daily fluctuation limits in an effort to discourage speculative tradings. In addition, this paper proposes how to derive endogenously elastic stock demand in a market with heterogeneous agents, while inelastic stock demand is a common feature in asset pricing formulas based on representative agent models. (JEL Classification: D82, D83, G12)