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The Evolution of Security Designs


We consider a competitive and perfect financial market in which agents have heterogeneous cash flow valuations. 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 affects security design profoundly, with securities mispriced even in the long run and optimal designs trading 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, but that otherwise produce stable payoffs, almost the exact opposite of the pure state claims that are optimal in the rational expectations framework. Copyright 2006 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 61 (2006)
Issue (Month): 5 (October)
Pages: 2103-2135

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Handle: RePEc:bla:jfinan:v:61:y:2006:i:5:p:2103-2135
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  1. Thomas H. Noe & Michael J. Rebello & Jun Wang, 2003. "Corporate Financing: An Artificial Agent-based Analysis," Journal of Finance, American Finance Association, vol. 58(3), pages 943-973, 06.
  2. Franklin Allen, Douglas Gale, 1988. "Optimal Security Design," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 229-263.
  3. Arifovic, Jasmina, 1994. "Genetic algorithm learning and the cobweb model," Journal of Economic Dynamics and Control, Elsevier, vol. 18(1), pages 3-28, January.
  4. H. Peyton Young, 1996. "The Economics of Convention," Journal of Economic Perspectives, American Economic Association, vol. 10(2), pages 105-122, Spring.
  5. Routledge, Bryan R., 2001. "Genetic Algorithm Learning To Choose And Use Information," Macroeconomic Dynamics, Cambridge University Press, vol. 5(02), pages 303-325, April.
  6. Brock, William A & LeBaron, Blake D, 1996. "A Dynamic Structural Model for Stock Return Volatility and Trading Volume," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 94-110, February.
  7. Gale, Douglas, 1992. "Standard Securities," Review of Economic Studies, Wiley Blackwell, vol. 59(4), pages 731-55, October.
  8. Arifovic, Jasmina, 1996. "The Behavior of the Exchange Rate in the Genetic Algorithm and Experimental Economies," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 510-41, June.
  9. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, 08.
  10. Allen, Franklin & Karjalainen, Risto, 1999. "Using genetic algorithms to find technical trading rules," Journal of Financial Economics, Elsevier, vol. 51(2), pages 245-271, February.
  11. repec:cup:macdyn:v:5:y:2001:i:2:p:303-25 is not listed on IDEAS
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