Asset Pricing Under Endogenous Expectations in an Artificial Stock Market

Abstract

This chapter proposes a theory of asset pricing based on heterogeneous agents who continually adapt their expectations to the market that these expectations aggregatively create. It explores the implications of this theory computationally using Santa Fe artificial stock market. 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. Academic theorists and market traders tend to view financial markets in strikingly different ways. Standard (efficient-market) financial theory assumes identical investors who share rational expectations of an asset&s;s future price, and who instantaneously and rationally discount all market information into this price. While a few academics would be willing to assert that the market has a personality or experiences moods, the standard economic view has in recent years begun to change.