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

We study equilibrium security price dynamics in an economy where nonfundamental risk arises from agents' heterogeneous beliefs about extraneous processes. We completely characterize equilibrium in terms of the economic primitives, via a representative agent with stochastic weights, Besides pricing fundamental risk, an agent now also prices nonfundamental risk with a market price which is a risk-tolerance weighted average of his extraneous disagreement with all remaining agents, Consequently, agents' perceived state prices and consumption are more volatile in the presence of extraneous risk, The interest rate inherits additional terms from: agents' misperceptions about consumption growth, and precautionary savings motives against the nonfundamental uncertainty. (C) 2000 Elsevier Science B.V. All rights reserved.