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RFS Advance Access originally published online on March 2, 2006
Review of Financial Studies 2006 19(3):719-752; doi:10.1093/rfs/hhj036
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Beauty Contests and Iterated Expectations in Asset Markets

Franklin Allen
University of Pennsylvania

Stephen Morris
Princeton University

Hyun Song Shin
Princeton University

Address correspondence to Hyun Song Shin, Princeton University, Bendheim Center for Finance, NJ 08540, or e-mail: hsshin{at}princeton.edu

In a financial market where traders are risk averse and short lived and prices are noisy, asset prices today depend on the average expectation today of tomorrow’s price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not, in general, equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher-order beliefs in a fully rational asset pricing model.


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