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Market Efficiency and Learning in an Endogenously Unstable Environment

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  • David Goldbaum

Abstract

\tTraders in this model of an asset market have the opportunity to conduct individual research to acquire a noisy signal of a security's future value, or they can employ least-squares learning in an attempt at extracting the private information of other traders through observing the price. For a fixed proportion of the traders using fundamental research, n, the model converges to a stable fixed point equilibrium. At the fixed point, the regression traders outperform the fundamental traders for all values of n > 0. The equilibrium suffers from a Grossman and Stiglitz (1980) type paradox of efficient markets. Endogenize n based on performance and the Grossman-Stiglitz paradox is alleviated. The model is characterized by an unstable fixed point. As the model converges towards the fixed point, the regression traders perform well. As n falls, the regression traders begin to have a substantial impact on the price, causing greater fluctuations in profits and in n. Inevitably, the actual n is significantly different than the value of n implicit in the regression traders' coefficient values, introducing error in the regression trader's forecast. This leads to substantial mispricing that results in losses to the regression traders. It also throws the model far from the fixed point, starting the convergence process over.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 105.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:105

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Keywords: Least squares learning; efficient markets; chaos;

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References

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  1. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
  2. Cheung, Yin-Wong & Friedman, Daniel, 1998. "A comparison of learning and replicator dynamics using experimental data," Journal of Economic Behavior & Organization, Elsevier, vol. 35(3), pages 263-280, April.
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  10. Bray, Margaret, 1982. "Learning, estimation, and the stability of rational expectations," Journal of Economic Theory, Elsevier, vol. 26(2), pages 318-339, April.
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Citations

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Cited by:
  1. Diks, C.G.H. & Dindo, P.D.E., 2006. "Informational differences and learning in an asset market with boundedly rational agents," CeNDEF Working Papers 06-11, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  2. Brock, W.A. & Hommes, C.H. & Wagener, F.O.O., 2006. "More hedging instruments may destabilize markets," CeNDEF Working Papers 06-12, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  3. Cars Hommes & Florian Wagener, 2008. "Complex Evolutionary Systems in Behavioral Finance," Tinbergen Institute Discussion Papers 08-054/1, Tinbergen Institute.
  4. Cars H. Hommes, 2005. "Heterogeneous Agent Models in Economics and Finance," Tinbergen Institute Discussion Papers 05-056/1, Tinbergen Institute.
  5. Cars H. Hommes, 2005. "Heterogeneous Agent Models in Economics and Finance," Tinbergen Institute Discussion Papers 05-056/1, Tinbergen Institute.
  6. Goldbaum, David & Panchenko, Valentyn, 2010. "Learning and adaptation's impact on market efficiency," Journal of Economic Behavior & Organization, Elsevier, vol. 76(3), pages 635-653, December.
  7. David Goldbaum, 2004. "On the Possibility of Informationally Efficient Markets," Computing in Economics and Finance 2004 139, Society for Computational Economics.
  8. Goldbaum, David, 2006. "Self-organization and the persistence of noise in financial markets," Journal of Economic Dynamics and Control, Elsevier, vol. 30(9-10), pages 1837-1855.
  9. Hommes, Cars, 2011. "The heterogeneous expectations hypothesis: Some evidence from the lab," Journal of Economic Dynamics and Control, Elsevier, vol. 35(1), pages 1-24, January.
  10. David Goldbaum, 2003. "Profitable technical trading rules as a source of price instability," Quantitative Finance, Taylor & Francis Journals, vol. 3(3), pages 220-229.
  11. David Goldbaum, 2013. "Learning and Adaptation as a Source of Market Failure," Working Paper Series 14, Economics Discipline Group, UTS Business School, University of Technology, Sydney.

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