Differences of Opinion and the Volume of Trade

Abstract

The standard models of financial markets assume that agents have identical probability beliefs but different utiity functions. The volume of trade in such models is therefore due to these taste differences. In this paper I investigate the implications of reversing this setup: I assume that tastes are identical but probability beliefs differ across the agents. In this sort of model the volume of trade depends only on the differences of opinion even in the presence of differential information. This is demonstrated in two models: a mean-variance model and an Arrow-Debreu model, which are closely related to earlier models by Grossman and Milgrom-Stokey. Having established the importance of differences of opinion I then consider their impact on asset markets in an Arrow-Debreu equilibrium. If risk tolerance grows less rapidly than it does in the case of logarithmic utility then increased dispersion of opinion will be associated with lower prices and higher volume of trade in equilibrium. If risk tolerance grows more rapidly than it does with logarithmic utility then increased dispersion of opinion will be associated with higher prices but the volume of trade may increase or decrease.