On the Kurz Model of Asset Prices with Rational Beliefs

Abstract

Kurz (1997) proposes an appealing model of asset pricing that appears to be an interesting example of a conditional CAPM. In the Kurz model, agents develop a diversity of inaccurate but rational beliefs through a Bayesian process. Kurz avoids the problematic issue of unobservable conditioning information by developing a general equilibrium model based upon rational beliefs, which means that agents do not know the demand functions of other agents, and therefore cannot compute equilibrium prices. They can, however, develop diverse beliefs that cannot be rejected by historical economic data. Such unrejectable beliefs are defined by Kurz to be rational, and lead to a continuum of Rational Belief Equilibria. Kurz uses the concept of endogenous uncertainty (EU), which measures the sum of agents' forecasting mistakes. To the extent asset price variance differs from variance in the exogenous fundamental economic variables, Kurz' approach attributes the difference to EU, or aggregate forecasting mistakes which are consistent with rational beliefs. To the extent that the Arrow-Debreau (1954) model is based exclusively on exogenous uncertainty, Kurz views this as "fundamentally flawed" and offers a new and interesting way to distinguish between exogenous and endogenous uncertainty. The most interesting aspect of such delineation is it supports the prior theory of Treynor and Black (1973) and Cvitanic et al (2002) on the existence and estimation of appraisal premia for capital assets, in a conditional CAPM framework.

Keywords: Kurz, CAPM, Conditional, Endogenous, General Equilibrium

JEL Classification: G12, G14