Global Public Signals, Heterogeneous Beliefs, and Stock Markets Comovement

Abstract

We build an information-based two-country general equilibrium model. There are two dividend processes with correlated growth rates. Agents observe a global public signal informative about both growth rates. We first let agents rationally process information, and then we allow for reasonable departures from rationality. That is, agents are overconfident with respect to the signal, and thus have heterogeneous beliefs. We report a significant increase in comovement between stock returns. Moreover, we find that a small amount of misinterpretation of the global signal is sufficient to generate sizable comovement, as compared to the benchmark case of rational expectations. As an additional implication of overconfidence, we show that our model is able to produce a substantial home equity bias.

Keywords: co-movement, home bias