Incomplete Information and Heterogeneous Beliefs in Continuous-time Finance

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This book considers the impact of incomplete information and heterogeneous beliefs on investor’s optimal portfolio and consumption behavior and equilibrium asset prices. After a brief review of the existing incomplete information literature, the effect of incomplete information on investors’ exptected utility, risky asset prices, and interest rates is described. It is demonstrated that increasing the quality of investors’ information need not increase their expected utility and the prices of risky assets. The impact of heterogeneous beliefs on investors’ portfolio and consumption behavior and equilibrium asset prices is shown to be non-trivial. Heterogeneous beliefs can explain a number of observed phenomena, such as the fact that equilibrium state-price densities are not log-normal, the smile in option implied volatility, and the patterns of implied risk aversion reported recently in the literature. It is also demonstrated that financial markets in general do not aggregate information efficiently, a fact that can explain the equity premium puzzle.