Economics Job Talk

Abstract: Higher order beliefs - beliefs about others' beliefs - may be important for trading behavior and asset prices, but have received little systematic empirical examination due to challenges in measurement. We circumvent these challenges using the insight that return expectations for an asset encode higher order beliefs, as they depend on forecasts of other investors' future demand. Analyzing survey data on the beliefs of U.S. equity market and global currency market investors, we find that the term structure of investors' cumulative return expectations follows a hump shape: when investors report high return expectations for the following month or quarter, they report low return expectations for subsequent quarters. We use novel survey data to directly relate this pattern to investors' higher order beliefs. Guided by the evidence, we construct a tractable asset pricing model that we use to theoretically and quantitatively explore investors' higher order beliefs and their impact on asset prices. In a quantitative application, we find that the higher order beliefs of financial institutions exhibit systematic biases, but nevertheless play a corrective role for exchange rates.