The Effect of Estimation Risk on Capital Market Equilibrium

Abstract

The solution to the problem of portfolio choice is relevant in a positive financial economics context because it provides models of individual maximizing behavior which when aggregated to the level of the market provide models of equilibrium asset pricing. These models generally assume that the parameters of the probability distribution of security returns are known to individual investors. In practice, however, the individual has to estimate these parameters. To the extent that there is parameter uncertainty or “estimation risk”, what are the observable implications of a market equilibrium derived on the assumption that the information set of all investors is equivalent to a given set of sample data?