The Investor Recognition Hypothesis in a Dynamic General Equilibrium: Theory and Evidence
September 1999
Alexander Shapiro
ABSTRACT
This paper analyzes equilibrium in a dynamic pure-exchange economy under a generalization of Merton's (1987) investor
recognition hypothesis (IRH). Because of information costs, a class of investors is assumed to possess incomplete
information, which suffices to implement only a particular trading strategy. The IRH is mapped into corresponding
portfolio restrictions that bind a subset of agents. The model is formulated in continuous time, and detailed characterization
of equilibrium quantities is provided. The model implies that, all else equal, a risk premium on a less visible
stock need not be higher than that on a more visible stock with a lower volatility -- contrary to results derived
in a static mean-variance setting. An empirical analysis suggests that a consumption-based capital asset pricing
model (CCAPM) augmented by the IRH is a more realistic model than the traditional CCAPM for explaining the cross-sectional
variation in unconditional expected equity returns.
Subject: Investments/Portfolio Choice; Investments/Market Efficiency; Investments/Econometrics
Classification: Theoretical /Empirical
Shapiro: (212) 998-0362 ashapiro@stern.nyu.edu
To download a copy of this paper click here
To request a copy of this paper click here
The Finance Department Working Paper Series has been generously sponsored by