Disagreement and Asset Prices

Higher-than-normal disagreement is linked to a positive risk premium.

When Wall Street traders disagree about the prospects for an asset, do investors who buy that asset receive a risk premium? In Disagreement and Asset Prices (NBER Working Paper No. 18619), authors Bruce Carlin, Francis Longstaff, and Kyle Matoba suggest that they do. Specifically, they show that market disagreement is associated with higher expected returns, higher return volatility, and more trading. They find that volatility by itself doesn't cause more trading; higher uncertainty leads to higher trading volume only when the market disagrees about an asset. Furthermore, when there is such disagreement, sophisticated investors appear to learn from prices and opinions in the market.

"Understanding how information gets incorporated into asset prices may be one of the most fundamental issues in finance," these authors explain. "Despite the fundamental nature of this issue, though, there still remains significant controversy in the literature about how disagreement risk affects expected returns and asset prices." Some theorists predict that disagreement should lead to a risk premium for investors who climb out on a limb. Others argue there's no premium, because pessimists sit out of the market, allowing prices to rise to what optimists believe they should be, as least when there are constraints on short sales.

Using a 20-year time series of Wall Street dealers' forecasts of the prepayment speed of federally guaranteed mortgage-backed securities, the authors explore this question. First, they build a disagreement index. They find a surprisingly high degree of disagreement about how quickly mortgages will be repaid, especially during major events, such as the 9/11 terrorist attacks and the Lehman Brothers default. Then they compare future realized returns of those securities against the disagreement index and other proxy measures of risk about those securities. They find that the more disagreement, the higher are the expected returns. This suggests that higher-than-normal disagreement is linked to a positive risk premium. Higher trading volume is followed by lower disagreement. The authors write that "as investors learn through trade, this gives them opportunities to update their beliefs about the drivers of asset value."

--Laurent Belsie