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Equilibrium Expectation Errors and Asset Pricing Anomalies
Subject
Asset Pricing
Date
2023
Motivation
Many standard models assume that investors are perfectly informed: they are homogeneous and know the gains/risks involved with the potential investments. In this paper, I relax this unrealistic assumption in the context of one of the most famous models in finance: the CAPM. By acknowledging the joint presence of expectation errors on both the return and risk dimensions, I provide a more realistic perspective on investor behavior and its impact on the pricing equilibrium.
Abstract: We study the Capital Asset Pricing Model (CAPM) with the perfect information assumption fully relaxed - that is, heterogeneous and biased beliefs on the asset means, variances and correlations. We show that not only exposures to the market return matter in equilibrium, but also exposures to the expectation errors. The pricing relationship becomes a four-dimensional space but can be conveniently expressed as a two-dimensional plane, the Security Market Plane (SMP). We provide an empirical procedure that allows to test for the out-of-sample pricing relevance of any exogenous mean-variance beliefs, given a set of observed prices. We use it to assess whether the beliefs implied by the Institutional Brokers' Estimate System (I/B/E/S) can explain well-known asset pricing anomalies such as the value, size and idiosyncratic volatility premia.