The Investor Recognition Hypothesis in a Dynamic General Equilibrium: Theory and Evidence

Abstract

This paper analyzes equilibrium in a dynamic pure-exchange economy under a generalization of Merton's (1987) investor recognition hypothesis (IRH). Because of information costs, a class of investors is assumed to possess incomplete information, which suffices to implement only a particular trading strategy. The IRH is mapped into corresponding portfolio restrictions that bind a subset of agents. The model is formulated in continuous time, and detailed characterization of equilibrium quantities is provided. The model implies that, all else equal, a risk premium on a less visible stock need not be higher than that on a more visible stock with a lower volatility -- contrary to results derived in a static mean-variance setting. An empirical analysis suggests that a consumption-based capital asset pricing model (CCAPM) augmented by the IRH is a more realistic model than the traditional CCAPM for explaining the cross-sectional variation in unconditional expected equity returns.