A model of dynamic equilibrium asset pricing with heterogeneous beliefs and extraneous risk

We study equilibrium security price dynamics in an economy where nonfundame ntal risk arises from agents' heterogeneous beliefs about extraneous proces ses. We completely characterize equilibrium in terms of the economic primit ives, via a representative agent with stochastic weights, Besides pricing f undamental risk, an agent now also prices nonfundamental risk with a market price which is a risk-tolerance weighted average of his extraneous disagre ement with all remaining agents, Consequently, agents' perceived state pric es and consumption are more volatile in the presence of extraneous risk, Th e interest rate inherits additional terms from: agents' misperceptions abou t consumption growth, and precautionary savings motives against the nonfund amental uncertainty. (C) 2000 Elsevier Science B.V. All rights reserved.