This paper embeds security design in a model of evolutionary learning. We consider a competitive and perfect financial market where agents, as in Allen and Gale (1988), have heterogeneous valuations for cash flows. Our point of departure is that, instead of assuming that agents are endowed with rational expectations, we model their behavior as the product of adaptive learning. Our results demonstrate that adaptive learning profoundly affects security design. Securities are mispriced even in the long run and optional designs trade off underpricing against intrinsic value maximization. The evolutionary dominant security design calls for issuing securities that engender large losses with a small but positive probability, and otherwise produce stable payoffs. These designs are almost the exact opposite of the pure state claims which are optimal in the rational expectations framework but are roughly consistent with what one would expect given the decision making heuristics documented in the behavioural economics literature.
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Paper provided by Institute for Financial Research in its series SIFR Research Report Series with number
26.
Length: 36 pages Date of creation: 15 Sep 2004 Date of revision: Handle: RePEc:hhs:sifrwp:0026
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Thomas H. Noe & Michael J. Rebello & Jun Wang, 2006.
"The Evolution of Security Designs,"
Journal of Finance,
American Finance Association, vol. 61(5), pages 2103-2135, October.
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Find related papers by JEL classification: C45 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Neural Networks and Related Topics D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information G12 - Financial Economics - - General Financial Markets - - - Asset Pricing G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
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Franklin Allen, Douglas Gale, 1988.
"Optimal Security Design,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 1(3), pages 229-263.
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