Asset Pricing Under Endogenous Expectations in an Artificial Stock Market

29 Pages Posted: 19 Feb 1997

See all articles by W. Brian Arthur

W. Brian Arthur

Santa Fe Institute

John H. Holland

University of Michigan

Blake LeBaron

Brandeis University - International Business School

Richard G. Palmer

Duke University

Paul Tayler


Date Written: Dec 12, 1996


We propose a theory of asset pricing based on heterogeneous agents who continually adapt their expectations to the market that these expectations aggregatively create. And we explore the implications of this theory computationally using our Santa Fe artificial stock market. Asset markets, we argue, have a recursive nature in that agents' expectations are formed on the basis of their anticipations of other agents' expectations, which precludes expectations being formed by deductive means. Instead traders continually hypothesize-continually explore-expectational models, buy or sell on the basis of those that perform best, and confirm or discard these according to their performance. Thus individual beliefs or expectations become endogenous to the market, and constantly compete within an ecology of others' beliefs or expectations. The ecology of beliefs co-evolves over time. 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. Both views, we show, are correct, but within different regimes. Within a regime where investors explore alternative expectational models at a low rate, the market settles into the rational-expectations equilibrium of the efficient-market literature. Within a regime where the rate of exploration of alternative expectations is higher, the market self-organizes into a complex pattern. It acquires a rich psychology, technical trading emerges, temporary bubbles and crashes occur, and asset prices and trading volume show statistical features-in particular, GARCH behavior-characteristic of actual market data.

JEL Classification: G12, G14

Suggested Citation

Arthur, W. Brian and Holland, John H. and LeBaron, Blake D. and Palmer, Richard G. and Tayler, Paul, Asset Pricing Under Endogenous Expectations in an Artificial Stock Market (Dec 12, 1996). Available at SSRN: or

W. Brian Arthur

Santa Fe Institute ( email )

1399 Hyde Park Road
1399 Hyde Park Rd.
Santa Fe, NM 87501
United States

John H. Holland

University of Michigan ( email )

Department of Pshycology
Ann Arbor, MI 48109
United States
313 763-3648 (Phone)

Blake D. LeBaron (Contact Author)

Brandeis University - International Business School ( email )

Mailstop 32
Waltham, MA 02454-9110
United States
781-736-2258 (Phone)
781-736-2269 (Fax)

Richard G. Palmer

Duke University ( email )

Department of Physics Box 90305
Durham, NC 27708
United States

Paul Tayler


No Address Available
United States

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