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Asset Pricing Under Endogenous Expectation in an Artificial Stock Market

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Author Info

  • W. Brian Arthur
  • John H. Holland
  • Blake LeBaron
  • Richard Palmer
  • Paul Taylor

Abstract

We propose a theory of asset pricing based on heterogeneous agents who continually adapt their expectations to the market that these expectations aggregatively create. And we explore the implications of this theory computationally using our Santa Fe artificial stock market. Asset markets, we argue, have a recursive nature in that agents' expectations are formed on the basis of their anticipations of other agents' expectations, which precludes expectations being formed by deductive means. Instead traders continually hypothesize---continually explore---expectational models, buy or sell on the basis of those that perform best, and confirm or discard these according to their performance. Thus individual beliefs or expectations become endogenous to the market, and constantly compete within an ecology of others' beliefs or expectations. The ecology of beliefs coevolves over time. Computer experiments with this endogenous-expectations market explain one of the more striking puzzles in finance: that market traders often believe in such concepts as technical trading, "market psychology," and bandwagon effects, while academic theorists believe in market efficiency and a lack of speculative opportunities. Both views, we show, are correct, but within different regimes. Within a regime where investors explore alternative expectational models at a low rate, the market settles into the rational-expectations equilibrium of the efficient-market literature. Within a regime where the rate of exploration of alternative expectations is higher, the market self-organizes into a complex pattern. It acquires a rich psychology, technical trading emerges, temporary bubbles and crashes occur, and asset prices and trading volume show statistical features---in particular, GARCH behavior---characteristic of actual market data.

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Bibliographic Info

Paper provided by Santa Fe Institute in its series Working Papers with number 96-12-093.

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Date of creation: Dec 1996
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Handle: RePEc:wop:safiwp:96-12-093

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Postal: 1399 Hyde Park Road, Santa Fe, New Mexico 87501
Web page: http://www.santafe.edu/sfi/publications/working-papers.html
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Keywords: Asset pricing; heterogeneous agents; endogeneous expectations; artificial stock market;

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References

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  1. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
  2. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  3. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
  4. Marengo, Luigi & Tordjman, Helene, 1996. "Speculation, Heterogeneity and Learning: A Simulation Model of Exchange Rates Dynamics," Kyklos, Wiley Blackwell, vol. 49(3), pages 407-38.
  5. Frankel, Jeffrey A & Froot, Kenneth A, 1990. "Chartists, Fundamentalists, and Trading in the Foreign Exchange Market," American Economic Review, American Economic Association, vol. 80(2), pages 181-85, May.
  6. Blume, Lawrence & Easley, David, 1992. "Evolution and market behavior," Journal of Economic Theory, Elsevier, vol. 58(1), pages 9-40, October.
  7. Diba, Behzad T & Grossman, Herschel I, 1988. "The Theory of Rational Bubbles in Stock Prices," Economic Journal, Royal Economic Society, vol. 98(392), pages 746-54, September.
  8. Michael Youssefmir & Bernardo A. Huberman, 1995. "Clustered Volatility in Multiagent Dynamics," Working Papers 95-05-051, Santa Fe Institute.
  9. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  10. David M. Cutler & James M. Poterba & Lawrence H. Summers, 1988. "What Moves Stock Prices?," NBER Working Papers 2538, National Bureau of Economic Research, Inc.
  11. Bossaerts, Peter, 1995. "The Econometrics of Learning in Financial Markets," Econometric Theory, Cambridge University Press, vol. 11(01), pages 151-189, February.
  12. Brock, W. & Lakonishok, J. & Lebaron, B., 1991. "Simple Technical Trading Rules And The Stochastic Properties Of Stock Returns," Working papers 90-22, Wisconsin Madison - Social Systems.
  13. Martin Shubik, 1996. "Time and Money," Cowles Foundation Discussion Papers 1112, Cowles Foundation for Research in Economics, Yale University.
  14. Andrew W. Lo & A. Craig MacKinlay, 1987. "Stock Market Prices Do Not Follow Random Walks: Evidence From a Simple Specification Test," NBER Working Papers 2168, National Bureau of Economic Research, Inc.
  15. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
  16. W. Brian Arthur, 1992. "On Learning and Adaptation in the Economy," Working Papers 854, Queen's University, Department of Economics.
  17. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring.
  18. Summers, Lawrence H, 1986. " Does the Stock Market Rationally Reflect Fundamental Values?," Journal of Finance, American Finance Association, vol. 41(3), pages 591-601, July.
  19. Blume, Lawrence E. & Easley, David, 1982. "Learning to be rational," Journal of Economic Theory, Elsevier, vol. 26(2), pages 340-351, April.
  20. repec:cup:etheor:v:11:y:1995:i:1:p:151-89 is not listed on IDEAS
  21. repec:att:wimass:9706 is not listed on IDEAS
  22. E.R. Grannan & G.H. Swindle, 1994. "Contrarians and Volatility Clustering," Working Papers 94-03-010, Santa Fe Institute.
  23. Friedman, Daniel & Aoki, Masanao, 1992. "Inefficient Information Aggregation as a," Bulletin of Economic Research, Wiley Blackwell, vol. 44(4), pages 251-79, October.
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