Abstract
We consider a Lucas-type exchange economy with two trees and two investors to analyze the effects of heterogeneous beliefs and signal quality on stock market equilibrium. Our model has the following implications. There are spillover effects, in that the investors’ heterogeneous beliefs and signal quality related to one stock not only affect its own price and pricing moments, but also affect those of the other. Contrary to the conventional wisdom, we show that the volatility of one stock decreases with both its own and the other stock’s disagreements. Additionally, we reveal a negative correlation between the stocks, which decreases as the investors’ dispersions raise but increases as the discrepancy in signal quality reduces. We also show that heterogeneous beliefs and signal quality impact stock market beta mainly through scale and volatility effects, respectively. Furthermore, our findings suggest that both heterogeneous beliefs and signal quality have significant influences on the investors’ optimal portfolio plans.
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