Pricing Two Heterogeneous Trees

Branger Nicole, Schlag Christian, Wu Lue


Abstract
We consider a Lucas-type exchange economy with two heterogeneous stocks ('trees') and a representative investor with constant relative risk aversion. The dividend process for one stock follows a geometric Brownian motion with constant and known parameters. The expected dividend growth rate for the other tree is stochastic and in general unobservable, although there may be a signal from which the investor can learn about its current value. We find that the equilibrium quantities in our model significantly depend on the information structure and on the level of risk aversion. While an observable stochastic drift mainly makes the economy more risky, a latent expected growth rate process with learning changes the equilibrium price-dividend ratios, price reactions to dividend and drift innovations, expected returns, volatilities, correlations, and differences between the stocks significantly. These effects are the more pronounced the more risk averse the representative investor.

Keywords
Asset Pricing; Two-Tree Economy; Learning; Stochastic Drift



Publication type
Research article (journal)

Peer reviewed
Yes

Publication status
Published

Year
2011

Journal
Journal of Financial and Quantitative Analysis

Volume
46

Issue
5

Start page
1437

End page
1462

Language
English

ISSN
0022-1090

DOI

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