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

Abstract

This article analyzes a dynamic general equilibrium under a generalization of Merton’s (1987) investor recognition hypothesis. A class of informationally constrained investors is assumed to implement only a particular trading strategy. The model implies that, all else being 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. A consumption-based capital asset pricing model (CAPM) augmented by the generalized investor recognition hypothesis emerges as a viable contender for explaining the cross-sectional variation in unconditional expected equity returns.