Speculation and Financial Wealth Distribution Under Belief Heterogeneity

Abstract

Under limited commitment that prevents agents from pledging their future non‐financial wealth, agents with incorrect beliefs always survive by holding on to their non‐financial wealth. Friedman's () market selection hypothesis suggests that their financial wealth trends towards zero in the long run. However, I present a dynamic general equilibrium model with incomplete markets due to collateral constraints and show that the hypothesis depends on the degree of market incompleteness. When markets are more incomplete, over‐optimistic agents not only survive but also prosper by speculation. Stricter margin requirements protect the wealth of the optimists and thereby increase asset price volatility.

The Wisdom of the Crowd in Dynamic Economies

“…In addition to our model, others in the market selection literature allow for long-run survival of agents with heterogeneous beliefs. Survival of agents with heterogeneous beliefs occurs in economies with incomplete markets (Beker and Chattopadhyay, 2010;Cogley et al, 2013;Cao, 2017), ambiguous averse agents (Guerdjikova and Sciubba, 2015), exogenous saving rules (Bottazzi and Dindo, 2014;Bottazzi et al, 2017), and recursive preferences (Borovička, 2015;Dindo, 2015). Unlike ours, however, these models do not deliver WOC because there is no feedback between agent beliefs and equilibrium prices.…”

Momentum and reversal in financial markets with persistent heterogeneity

“…Other contributions in the literature considers the outcome of market selection with endogenous portfolios both in discrete time (Sandroni, 2000;Blume and Easley, 2006;Jouini and Napp, 2006) and in continuous time (Jouini and Napp, 2007;Yan, 2008;Cvitanić et al, 2012). Within this Market Selection literature, other models achieve long-run heterogeneity as a result of incomplete markets (Blume and Easley, 2006;Beker and Chattopadhyay, 2010;Coury and Sciubba, 2012), non-tradable labor income (Cogley et al, 2013;Cao, 2017), ambiguity aversion (Condie, 2008;Guerdjikova and Sciubba, 2015), asymmetric and costly information (Sciubba, 2005), non-converging learning (Sandroni, 2005;Beker and Espino, 2011), recursive preferences (Borovička, 2015;Dindo, 2015), solvency constraints (Beker and Espino, 2015). In particular, Beker and Espino (2015) highlight the role that belief heterogeneity and limited enforceability may play for generating short-term momentum and long-term reversal.…”

Real Exchange Rate Dynamics Beyond Business Cycles

“…methods developed by Devereux and Sutherland (2010), Tille and van Wincoop (2010)a n dEvans and Hnatkovska (2012) approximate the equilibrium around the steady state, whereas we adapt the global solution method in Cao (2010Cao ( , 2018toaccommodateportfolioc hoice. 5,6 The use of a global solution method allows us to examine how the exchange-rate implications of productivity shocks critically depend on the economy's proximity to the borrowing constraint.…”

“…These solution methods have been used to study external adjustment (see, e.g.,Tille andvan Wincoop, 2010 and Evans, 2014) and origins of home bias in international portfolio holdings (see, e.g.,Coeurdacier and Gourinchas, 2008, Hnatkovska, 2009, Engel and Matsumoto, 2009, Coeurdacier et al, 2010, Devereux and Sutherland, 2010,a n dCoeurdacier and Rey, 2012).6 We extend the solution method inCao (2010Cao ( , 2018 to allow for endogenous capital accumulation, imperfect substitution between traded goods, and up to five continuous state variables.…”