The Role of Diverse Beliefs in Asset Pricing and Equity Premia

by Mordecai Kurz and Maurizio Motolese A very preliminary draft: February 2, 2010 Summary: Why do risk premia vary over time? We examine this problem theoretically and empirically by studying the effect of market belief on risk premia. Individual belief is taken as a fundamental, primitive, state variable. Market belief which is the distribution of individual beliefs is observable, it is central to the empirical evaluation and we show how to measure it. Our asset pricing model is familiar from the noisy REE literature but we adapt it to an economy with diverse beliefs. We derive equilibrium asset prices and implied risk premium. Our approach permits a closed form solution of prices hence we trace the exact effect of market belief on the time variability of asset prices and risk premia. We test empirically the theoretical conclusions. We study premia on long positions of S&P500 for investment periods of 6 -12 months and find that, on average, a change in the mean market belief by 1 standard deviation changes equity premia by about 0.4 standard deviation of excess returns. We also find that the introduction of belief variables reduces the effect of the traditional Fama and French (1989) variables used to forecast excess returns. More specifically we find that given information about market belief the term premium, the default premium and Lattau and Ludvigson’s (2001) CAY variables have no significant effect. As to the structure of the premium we show that when the market holds abnormally favorable belief about the future payoff on the S&P500 the market views the long position as less risky hence the equity risk premium declines. We also find that in a VAR model of asset and consumption growth, our market belief variables have a significant effect. We thus conclude that market belief has significant independent effect on economic fluctuations and risk premia. JEL classification: C53, D8, D84, E27, E4, G12, G14.