Trading Complex Risks

Abstract

This paper studies how complexity impacts markets’ ability to aggregate information and distribute risks. I amend fundamental asset pricing theory to reflect agents’ imperfect knowledge about complex dividend distributions and test its clear-cut predictions in the laboratory. Market equilibria corroborate complexity-averse trading behavior. Despite being overpriced, markets efficiently share complex risks between buyers and sellers. While complexity induces noise in individual trading decisions, market outcomes remain theory-consistent. This striking feature reconciles with a random choice model, where bounds on rationality are reinforced by complexity. Furthermore, apparent self-awareness of estimation biases increases the efficiency and reduces the fluctuations of market-clearing prices.

Keywords: Complexity, risk sharing, information aggregation, bounded rationality, discontinuous trading

JEL Classification: G12, G14, G41