Efficient markets and Bayes’ rule

Alvaro Sandroni ()

Economic Theory, 2005, vol. 26, issue 4, 764 pages

Abstract: A series of financial anomalies motivated the development of new theories that modify the rational expectations ideal. Two possibilities have been systematically explored. The literature on behavioral finance relaxes the assumption that agents form beliefs according to the laws of probability and assume, instead, that simpler heuristic rules are used. Another stream of the literature assumes that agents process information according to Bayes’ rule, but do not posses sufficient information to know the true data generating process. In this paper, Bayesian and Behavioral agents coexist and trade in a standard dynamic asset pricing model. A long-standing conjecture is demonstrated. It is shown that, under suitable assumptions, Bayesian agents drive Behavioral, non-Bayesian agents out of the market. Hence, asset prices are eventually determined under the Bayesian paradigm. Copyright Springer-Verlag Berlin/Heidelberg 2005

Keywords: Bayes’ Rule; Wealth accumulation. (search for similar items in EconPapers)
Date: 2005
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Citations: View citations in EconPapers (7)

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DOI: 10.1007/s00199-004-0567-4

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