Determinants of stock market volatility and risk premia.

We show the dynamics of diverse beliefs is the primary propagation\r\nmechanism of volatility in asset markets. Hence, we treat the characteristics of the\r\nmarket beliefs as a primary, primitive, explanation of market volatility. We study\r\nan economy with stock and riskless bond markets and formulate a financial equilibrium\r\nmodel with diverse and time varying beliefs. Agents¿ states of belief play\r\na key role in the market, requiring an endogenous expansion of the state space.\r\nTo forecast prices agents must forecast market states of belief which are beliefs of\r\n"others" hence our equilibrium embodies the Keynes "Beauty Contest." A "market\r\nstate of belief" is a vector which uniquely identifies the distribution of conditional\r\nprobabilities of agents.\r\nRestricting beliefs to satisfy the rationality principle of Rational Belief (see\r\nKurz, 1994, 1997) our economy replicates well the empirical record of the (i)\r\nmoments of the price/dividend ratio, risky stock return, riskless interest rate and\r\nthe equity premium; (ii) Sharpe ratio and the correlation between risky returns and\r\nconsumption growth; (iii) predictability of stock returns and price/dividend ratio as\r\nexpressed by: (I)Variance Ratio statistic for long lags, (II) autocorrelation of these\r\nvariables, and (III) mean reversion of the risky returns and the predictive power of\r\nthe price/dividend ratio. Also, our model explains the presence of stochastic volatility\r\nin asset prices and returns. Two properties of beliefs drive market volatility:\r\n(i) rationalizable over confidence implying belief densities with fat tails, and (ii)\r\nrationalizable asymmetry in frequencies of bull or bear states.