This research delves into how mental models of pricing in financial markets shape return expectations. The primary objective of finance lies in pricing risks, where the level of mispricing indicates the degree of market inefficiency. As highlighted in research, expectations play a very important role when it comes to studying financial markets; empirically, significant heterogeneity exists in expectations. During the Inquire UK fall Seminar, Rob Bauer presented his research written in collaboration with Katrin Gödker, Florian Zimmermann, and Paul Smeets, ‘Mental Models in Financial Markets: How Do Experts Reason About the Pricing of Climate Risk?’, aiming to measure mental models and demonstrate their causal effect on expectations, providing evidence from finance experts and additionally applying their findings to a novel and highly pertinent risk in the financial market: Climate risk.

For those who were unable to attend his presentation, a summary has been made:
“In this paper, we examine the ways in which finance professionals (that are members of the CFA institute) reason about the capacity of financial markets to accurately price climate risks, as well as the relationship between this reasoning and the heterogeneity of return expectations. They work in various roles such as analysts, traders, fund managers, and CFOs at financial institutions and come from the US, Europe and Asia, making up our global sample. This is a particularly intriguing sample because finance professionals have a big impact on asset values, moving most of the money in the market.
Our study demonstrates significant regional and political variance in such opinions. For example, individuals in the US with left-leaning political views often think that other participants in the market are overlooking climate risks, while those with right-leaning perspectives see an excessive focus on climate risks. This heterogeneity in expert’s beliefs regarding the pricing of climate risk can also help clarify why there are variations in their expectations for returns.
We also investigate the reasons why market participants do no act on their beliefs to rectify this undervaluing of climate concerns. We demonstrate that a large number of experts think that mispricing will continue due to second-order beliefs. These assumptions regarding the enduring mispricing of climate risks have significant implications for asset pricing both in and out of equilibrium.
Experts’ estimates for returns are influenced by their varying views of climate hazards; many argue that current pricing does not fairly reflect these risks. By textual analysis of survey replies, we are able to distinguish between two primary mental models (informational challenges and second-order beliefs) that account for experts’ return expectations.
Financial markets heavily rely on these second- order beliefs, which are perceptions of other people’s opinions. Although the exact duration of climate risk mispricing is debatable, the majority of experts believe it will last for a number of years, which begs the issue of why opportunities are not taken advantage of. Overall, we see that geographical location and political philosophies have a big impact on specialists’ mental models, their line of reasoning. We additionally discover that return expectations are casually impacted by second-order beliefs”.
View the research in full via Joint Spring Seminar 2024, United Kingdom • Inquire Europe (inquire-europe.org)