On Overconfidence, Bubbles and the Stochastic Discount Factor

This study is intended to provide a continuous-time equilibrium model in which overconfidence generates disagreements among two groups regarding asset fundamentals. Every agent in trading wants to sell more than the average stock price in the market. However, the overconfident agent drives a speculative bubble with a false belief that the stock price will tend to move to the average price over time. I represent the difference between a false belief and a stochastic stationary process which does not change when shifted in time. The gap of beliefs shows how to accommodate dynamic fluctuations as parameters change such as the degree of overconfidence or the information of signals. By showing how changes in an expectation operator affect the stochastic variance of economic fundamentals, speculative bubbles are revealed at the burst independently from the market.