Heterogeneous beliefs with preference interdependence and asset pricing

Abstract

We study the equilibrium implications of heterogeneous beliefs and preference interdependence on the dynamics of asset prices and the resulting market behaviors. For the purpose of capturing the preference interdependence, we allow each investor’s utility not only depends their own terminal wealth, but also depends on the other one’s. We show that the preference interdependence generates a form of “herding behavior”, that induces the investors’ beliefs to coverage with each other. Therefore, the degree of the influences of the heterogeneous beliefs is attenuated. We also present that the heterogeneous beliefs impose negative effects on the prices of stocks and call options, whereas generate positive effects on the prices of put options. Due to the attenuation effect, the preference interdependence can have a strong promoting effect on the prices of stocks and call options and a strong depressing effect on the prices of put options. Furthermore, the attenuation effect also imposes a strong depressing effect on the volatilities of stocks even there exists high degree of heterogeneous beliefs among the investors. Finally, we present that both the heterogeneous beliefs and the preference interdependence can result in co-movement between stock and option markets.