Incomplete information and heterogeneous beliefs in continuous-time finance. With foreword by Heinz Zimmermann. (Q1885523)

The book to be reviewed is a revised version of the author's habilitation (postdoctoral) thesis. It is concerned with the analysis of the effects of incorporating incomplete information and heterogeneous beliefs in continuous-time financial models and thus tries to give an explanation to various empirical phenomena. Therefore, the book is mainly addressed to researchers and graduate students in the fields of economics or finance. However, interested practitioners may also be counted to its target audience. In the first chapter, an overview is presented of the existing literature on incomplete information in modelling portfolio choice, the term structure of interest rates and asset prices. This topic is interesting insofar as in the real world investors must first estimate expected returns and volatility either from fundamentals or market data, since they are in general unknown, and then optimize their portfolio given these estimates. It is shown that in general an incomplete information economy can be reduced to a complete information economy by using an appropriate choice of state variables. Next, the impact of incomplete information on utility, prices and interest rates under homogeneous beliefs is analysed in a simple continuous-time representative agent economy. It is shown that in general utility and asset prices do not necessarily rise when the information quality is increased. In the subsequent chapter, the author presents a model of optimal portfolio choice under heterogeneous beliefs. A discussion follows of the consequences which these types of belief have for an individual price-taking agent's portfolio composition. The effects of heterogeneous beliefs on the agent's optimal consumption choice are the subject of the fourth chapter. This is followed by an examination of equilibrium asset pricing under heterogeneous beliefs. Here, consumption can be considered as a bridge between heterogeneous beliefs and the equilibrium equivalent martingale measure. It is observed that heterogeneous beliefs can cause a smile on the option's implied volatility. Finally, in the last chapter, costly information, imperfect learning and information aggregation are considered. To summarize, the book presents an interesting source for those readers interested in the interplay of (micro-) economics and finance, i.e. of incomplete information, heterogeneous beliefs and continuous-time financial models. Finally, it should be noted, that some parts of the book have already been published in various journals. One minor drawback of the book is that some important and closely related earlier publications have not been mentioned, e.g. \textit{F. Riedel} [Eur. Finance Rev. 4, No. 1, 51--67 (2000; Zbl 0970.91045); Imperfect information and investor heterogeneity in the bond market (Contributions to Economics, Heidelberg: Physica) (1999; Zbl 0947.91040); J. Econ. Theory 97, No. 1, 109--122 (2001; Zbl 0994.91039)].