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

By Roger Farmer, Carine Nourry and Alain Venditti

http://d.repec.org/n?u=RePEc:aim:wpaimx:1311&r=dge

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 incompleteness 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.

That birth and death matters should be no surprise. As in overlapping generation models, the fact that the yet-to-be-born cannot trade with current generations leads to inefficiencies. That discount factor heterogeneity matters here is more of a surprise, at least to me. I would have expected this to simply to two classes of agents, one borrowing to the limit, the other accumulating to the other limit and that each category would otherwise enjoy efficient allocations, just with a higher discount rate due to the risk pf death. Apparently this is more complex than I thought.

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

  1. M. H. says:

    I agree with CZ that I do not understand with discount factor heterogeneity by itself would matter for multiplicity. It there some path dependence stemming from the OLG structure and its incomplete markets?

  2. Roger Farmer says:

    Yes there is.

    A positive human wealth shock in t+1 leads to a transfer from existing agents at date t to the t+1 newborns. A negative human wealth shock leads to transfer in the reverse direction. Since existing agents have different discount factors, they also have a different marginal propensity to consume out of wealth. That difference causes patient agents to lend to impatient agents in way that validates the human wealth shock.

    A positive human wealth shock is associated with a fall in the stochastic discount factor and a new path of future discount factors that converges back to the steady state from below.

    A negative human wealth shock is associated with an increase in the stochastic discount factor and a new path of future discount factors that converges back to the steady state from above.

    In the steady state, patient agents have an increasing consumption profile and impatient agents have a decreasing consumption profile. The age distribution of each type is exponential with many young agents and very few old ones.

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