Model Disagreement and Economic Outlook
We study the impact of model disagreement on the dynamics of asset prices, return volatility, and trade in the market. In our continuous-time framework, two investors have homogeneous preferences and equal access to information, but disagree about the length of the business cycle. We show that model disagreement amplifies return volatility and trading volume by inducing agents to have different economic outlooks, which generates a term structure of disagreement. Different economic outlooks imply that investors will trade even if they do not disagree about the current value of fundamentals. Also, we find that while the absolute level of return volatility is driven by long-run risk, the variation and persistence of volatility (i.e., volatility clustering) is driven by disagreement. Compared to previous studies that consider model uncertainty with a representative agent or those that study heterogeneous beliefs with no model disagreement, our paper offers a theoretical foundation for the GARCH-like behavior of stock returns.
We would like to thank Tony Berrada, Mike Chernov, Julien Cujean, Jerome Detemple, Bernard Dumas, Barney Hartman-Glaser, Julien Hugonnier, Arvind Krishnamurthy, Francis Longstaff, Hanno Lustig, Nick Roussanov, Pascal St.-Amour, Wei Xiong, and Hongjun Yan for their useful advice. We would also like to acknowledge comments from conference and seminar participants at the SFI meeting in Gerzensee, the International Forum on Long-Term Risks in Paris, UCLA Anderson, and the SFS Finance Cavalcade. Financial support from the Swiss Finance Institute, NCCR FINRISK of the Swiss National Science Foundation, UCLA, and the University of Toronto is gratefully acknowledged. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.