Selection in asset markets: the good, the bad, and the unknown
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In this paper, we use a series of simple examples to illustrate how wealth-driven selection works in a market for Arrow securities. Our analysis delivers both a good and a bad message. The good message is that, when traders invest constant fractions of their wealth in each asset and have equal consumption rates, markets are informationally efficient: the best informed agent is rewarded and asset prices eventually reflect this information. However, and this is the bad message, when asset demands are not constant fractions of wealth but dependent upon prices, markets might behave sub-optimally. In this case, asymptotic prices depend on preferences and beliefs of the whole ecology of traders and do not, in general, reflect the best available information. We show that the key difference between the two cases lies in the local, i.e. price dependent, versus global nature of wealth-driven selection.
KeywordsMarket selection Evolutionary Finance Informational efficiency Asset pricing CRRA preferences
JEL ClassificationsD50 D80 G11 G12
We acknowledge financial support from the Institute for New Economic Thinking, INET inaugural grant #220 and the European Commission 6th FP Project DIME (Contract CIT3-CT-2005-513396). All usual disclaimers apply.
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