Market Selection and Asset Pricing for the Handbook of Financial Markets : Dynamics and Evolution (original) (raw)

Selection in asset markets: the good, the bad, and the unknown

Journal of Evolutionary Economics, 2013

In this paper, we use a series of simple examples to illustrate how wealthdriven selection works in a market for Arrow securities. Our analysis delivers both a good and a bad message. The good message is that, when traders invest constant fractions of their wealth in each asset and have equal consumption rates, markets are informationally efficient: the best informed agent is rewarded and asset prices eventually reflect this information. However, and this is the bad message, when asset demands are not constant fractions of wealth but dependent upon prices, markets might behave sub-optimally. In this case, asymptotic prices depend on preferences and beliefs of the whole ecology of traders and do not, in general, reflect the best available information. We show that the key difference between the two cases lies in the local, i.e. price dependent, versus global nature of wealth-driven selection.

Wealth Selection in a Financial Market with Heterogeneous Agents

2007

We study the co-evolution of asset prices and agents' wealth in a financial market populated by an arbitrary number of heterogeneous, boundedly rational, investors. We model assets' demand to be proportional to agents' wealth, so that wealth dynamics can be used as a selection device. For a general class of investment behaviors, we are able to characterize the long run market outcome, i.e. the steady-state equilibrium values of asset return, and agents' survival. Our investigation illustrates that market forces pose certain limits on the outcome of agents' interactions even within the "wilderness of bounded rationality". As an application we show that our analysis provides a rigorous explanation for the results of the simulation model introduced in Levy, Levy, and Solomon (1994).

Wealth-driven Selection in a Financial Market with Heterogeneous Agents

2009

We study the co-evolution of asset prices and individual wealth in a financial market populated by an arbitrary number of heterogeneous, boundedly rational agents. Using wealth dynamics as a selection device we are able to characterize the long run market outcomes, i.e. asset returns and wealth distributions, for a general class of investment behaviors. Our investigation illustrates that market interaction and wealth dynamics pose certain limits on the outcome of agents' interactions even within the "wilderness of bounded rationality". As an application we consider the case of heterogeneous meanvariance optimizers and provide insights into the results of the simulation model introduced by Levy, Levy and Solomon (1994).

Procedural rationality, asset heterogeneity and market selection

Journal of Mathematical Economics, 2019

We extend the agent-based model of Anufriev and Bottazzi (2010) to the case with many risky assets. We show that under the procedural equilibrium, all assets with nonzero aggregate demand must have the same price returns. Heterogeneity in price returns appears when some assets face zero demand. In this case, the returns are essentially driven by the matrix of wealth-weighted products between demands and they generate a rich variety of patterns for agents' market shares. We formalize the dynamics of deterministic skeletons in our market model and consider the associated Jacobian matrix, for which we provide a closed form expression up to a matrix inversion. We then introduce the characteristic ratio of an investment strategy, which involves the average dividend yields of the risky assets and the investors' portfolio compositions. When equilibrium returns are uniform and when the number of assets is not smaller than the number of agents, the equilibrium with a single survivor can only be stable if the survivor has the maximal characteristic ratio. Moreover, we prove that this stability criterion holds as long as the noise in the system is sufficiently small. We confirm all our findings with a thorough empirical analysis of numerical simulations, with and without noise. All in all, our results form a theoretical rationale for portfolio strategies tilted towards firms that pay high dividend yields.

Catching Up with the Joneses: Heterogeneous Preferences and the Dynamics of Asset Prices

Journal of Political Economy, 2002

We examine how cross-sectional heterogeneity in preferences affects equilibrium behavior of asset prices. We obtain explicit characterization of the competitive equilibrium in an exchange economy in which individual agents have catching up with the Joneses preferences and differ only with respect to the curvature of their utility functions. We show that heterogeneity can have a drastic effect on the behavior of asset prices, in particular, on their conditional moments. Dynamic redistribution of wealth among the agents in heterogeneous economies leads to time-variation in aggregate risk aversion and market price of risk, generating empirically observed negative relation between conditional return volatility and expected returns on one hand and the level of stock prices on the other hand. This stands in contrast with the behavior of homogeneous economies with the same preferences, in which such relation is positive. Quantitatively, the heterogeneous model is capable of replicating various empirical properties of asset prices.

Asset price and wealth dynamics in a financial market with heterogeneous agents

Journal of Economic Dynamics and Control, 2006

This paper considers a discrete-time model of a financial market with one risky asset and one risk-free asset, where the asset price and wealth dynamics are determined by the interaction of two groups of agents, fundamentalists and chartists. In each period each group allocates its wealth between the risky asset and the safe asset according to myopic expected utility maximization, but the two groups have heterogeneous beliefs about the price change over the next period: the chartists are trend extrapolators, while the fundamentalists expect that the price will return to the fundamental. We assume that investors' optimal demand for the risky asset depends on wealth, as a result of CRRA utility. A market maker is assumed to adjust the market price at the end of each trading period, based on excess demand and on changes of the underlying reference price. The model results in a nonlinear discrete-time dynamical system, with growing price and wealth processes, but it is reduced to a stationary system in terms of asset returns and wealth shares of the two groups. It is shown that the longrun market dynamics are highly dependent on the parameters which characterize agents' behaviour as well as on the initial condition. Moreover, for wide ranges of the parameters a (locally) stable fundamental steady state coexists with a stable 'non-fundamental' steady state, or with a stable closed orbit, where only chartists survive in the long run: such cases require the

If You're so Smart, why Aren't You Rich? Belief Selection in Complete and Incomplete Markets

Econometrica, 2006

This paper provides an analysis of the asymptotic properties of Pareto optimal consumption allocations in a stochastic general equilibrium model with heterogeneous consumers. In particular we investigate the market selection hypothesis, that markets favor traders with more accurate beliefs. We show that in any Pareto optimal allocation whether each consumer vanishes or survives is determined entirely by discount factors and beliefs. Since equilibrium allocations in economies with complete markets are Pareto optimal, our results characterize the limit behavior of these economies. We show that, all else equal, the market selects for consumers who use Bayesian learning with the truth in the support of their prior and selects among Bayesians according to the size of their parameter space. Finally, we show that in economies with incomplete markets these conclusions may not hold. With incomplete markets payoff functions can matter for long run survival, and the market selection hypothesis fails.

2007) “Prices and Portfolio Choices in Financial Markets: Theory

2007

Many tests of asset-pricing models address only the pricing predictions, but these pricing predictions rest on portfolio choice predictions that seem obviously wrong. This paper suggests a new approach to asset pricing and portfolio choices based on unobserved heterogeneity. This approach yields the standard pricing conclusions of classical models but is consistent with very different portfolio choices. Novel econometric tests link the price and portfolio predictions and take into account the general equilibrium effects of sample-size bias. This paper works through the approach in detail for the case of the classical capital asset pricing model (CAPM), producing a model called CAPM + . When these econometric tests are applied to data generated by large-scale laboratory asset markets that reveal both prices and portfolio choices, CAPM+ is not rejected.