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The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World

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Abstract

Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents’ discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.

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Bibliographic Info

Paper provided by Aix-Marseille School of Economics, Marseille, France in its series AMSE Working Papers with number 1311.

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Length: 47 pages
Date of creation: 26 Feb 2013
Date of revision: 26 Feb 2013
Handle: RePEc:aim:wpaimx:1311

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Web page: http://www.amse-aixmarseille.fr/en
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Keywords: Inefficient markets; heterogeneous agents; overlapping generations; sunspots; extrinsic uncertainty; excess volatility.;

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As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World
    by Christian Zimmermann in NEP-DGE blog on 2013-03-15 19:50:06
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Cited by:
  1. Farmer, Roger E A, 2014. "Asset Prices in a Lifecycle Economy," CEPR Discussion Papers 9897, C.E.P.R. Discussion Papers.
  2. de la Torre, Augusto & Ize, Alain, 2013. "The foundations of macroprudential regulation : a conceptual roadmap," Policy Research Working Paper Series 6575, The World Bank.
  3. Farmer, Roger E A, 2013. "The Natural Rate Hypothesis: An idea past its sell-by-date," CEPR Discussion Papers 9580, C.E.P.R. Discussion Papers.
  4. Beniamino Moro, 2013. "The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US," Ekonomi-tek - International Economics Journal, Turkish Economic Association, vol. 2(1), pages 41-77, January.

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