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

  • Roger E.A. Farmer
  • Carine Nourry
  • Alain Venditti

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 in completeness 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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18647.

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Date of creation: Dec 2012
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Handle: RePEc:nbr:nberwo:18647
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  14. Roger E.A. Farmer & Jang Ting Guo, 1992. "Real Business Cycles and the Animal Spirits Hypothesis," UCLA Economics Working Papers 680, UCLA Department of Economics.
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  28. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  29. Wen, Yi, 1998. "Capacity Utilization under Increasing Returns to Scale," Journal of Economic Theory, Elsevier, vol. 81(1), pages 7-36, July.
  30. Christopher J. Malloy & Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2009. "Long-Run Stockholder Consumption Risk and Asset Returns," Journal of Finance, American Finance Association, vol. 64(6), pages 2427-2479, December.
  31. Barsky, Robert B & De Long, J Bradford, 1993. "Why Does the Stock Market Fluctuate?," The Quarterly Journal of Economics, MIT Press, vol. 108(2), pages 291-311, May.
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