Asset prices and trading in complete market economies with heterogeneous agents

This thesis examines how and to what extend certain types of heterogeneity of agents in an economy with complete financial markets can explain the variation in aggregate prices and the volume of trade that we observe. There are a number of characteristics of the financial markets that have been particularly puzzling researchers; most important of which are the fact that the level of the market is on average low in comparison to interest rates, it varies a lot over time while the fundamentals of the economy do not and the fact that agents trade too much to be justified by the standard view that we hold for the economy. One clue that is found in the data is that the amount of trading is related to prices in a couple of ways like volatility or whether the market is moving upwards or downwards. This implies that the market is moved partly by the same forces that make agents to trade and at the basis of it is that agents are heterogeneous. I consider two types of heterogeneities in three separate studies. I first analyze an economy where agents differ in their risk preferences and I find with a realistic set of parameters that it cannot be a noticeable driver of the phenomena that I examine. In the other two studies I look at economies where agents differ in their beliefs about the future. These two studies yield a number of positive results: (i) high variation in the level of the prices can be explained by variations in the level of heterogeneity of beliefs and in particular the phenomenal increase in prices over the 1990s, (ii) price characteristics can be connected with trading volume through sentiment risk which determines how volatile individual beliefs are, and (iii) both heterogeneity of beliefs as well as sentiment risk could possibly explain the low level of prices. The studies are mostly theoretical but some empirical support is provided.