Market Selection

41 Pages Posted: 4 Aug 2009 Last revised: 5 Jul 2010

See all articles by Leonid Kogan

Leonid Kogan

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Stephen A. Ross

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Yale University - International Center for Finance

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

Mark M. Westerfield

University of Washington

Multiple version iconThere are 3 versions of this paper

Date Written: July 2009

Abstract

The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders' consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

Suggested Citation

Kogan, Leonid and Ross, Stephen A. and Wang, Jiang and Westerfield, Mark M., Market Selection (July 2009). NBER Working Paper No. w15189. Available at SSRN: https://ssrn.com/abstract=1442653

Leonid Kogan (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER)

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Stephen A. Ross

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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Yale University - International Center for Finance

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Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

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National Bureau of Economic Research (NBER)

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United States

Mark M. Westerfield

University of Washington ( email )

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United States

HOME PAGE: http://www.markwesterfield.com

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