Evolutionary metaphors have been prominent in both economics and finance. They are often used as basic foundations for rational behavior and efficient markets. Theoretically, a mechanism which selects for rational investors actually requires many caveats, and is far from generic. This paper tests wealth based evolution in a simple, stylized agent-based financial market. The setup borrows extensively from current research in finance that considers optimal behavior with some amount of return predictability. The results confirm that with a homogeneous world of log utility investors wealth will converge onto optimal adaptive forecasting parameters. However, in the case of utility functions which differ from log, wealth selection alone converges to parameters which are economically far from the optimal forecast parameters. This serves as a strong reminder that wealth selection and utility maximization are not the same thing. Therefore, suboptimal financial forecasting strategies may be difficult to drive out of a market, and may even do quite well for some time.

• “Decision-based methods for forecast evaluation”, (with M. Hashem Pesaran) in Companion to Economic Forecasting, M.P. Clements and D.F. Hendry (Eds), 2001,

This paper formalizes the idea that more hedging instruments may destabilize markets when traders are heterogeneous and adapt their behavior according to experience based reinforcement learning. We investigate three different economic settings, a simple mean-variance asset pricing model, a general equilibrium two-period overlapping generations model with heterogeneous expectations and a noisy rational expectations asset pricing model with heterogeneous information signals. In each setting the introduction of additional Arrow securities can destabilize the market, causing a bifurcation of the steady state to multiple steady states, periodic orbits or even chaotic fluctuations.

We show that competitive markets protect consumers from many forms of exploitation, even when consumers have non-standard preferences. We analyze a competitive dynamic economy in which consumers have arbitrary time-separable preferences and arbitrary beliefs about their own future behavior. Competition among agents eliminates rents and protects vulnerable consumers, who could have been exploited by a monopolist. In fact, in competitive general equilibrium no consumer participates in a trading sequence that strictly reduces her endowment { there are no Dutch Books. The absence of Dutch Books in and of itself does not distinguish standard and non-standard preferences. However, non-standard preferences do generate qualitatively di erent equilibrium outcomes than standard preferences. We characterize the testable implications of the standard model with a dynamic generalization of the Strong Axiom of Revealed Preferences.

The basic paradigm of asset pricing is in vibrant flux. The purely rational approach is being subsumed by a broader approach based upon the psychology of investors. In this approach, security expected returns are determined by both risk and misvaluation. This survey sketches a framework for understanding decision biases, evaluates the a priori arguments and the capital market evidence bearing on the importance of investor psychology for security prices, and reviews recent models. The best plan is...to profit by the folly of others.

Abstract What is the characterization of asset prices and investor’s behavior under myopic or time-inconsistent preferences? This paper investigates the characterization of financial market equilibrium when individuals are myopic or time-inconsistent. We consider an infinite horizon economy under certainty with two heterogeneous CRRA individuals, one good and one long-lived asset. The question of survival in the market arises when individuals are time-inconsistent or myopic with wrong expectations about equilibrium asset prices. We provide sufficient conditions such that the individual with intertemporal elasticity of substitution (IES) close or equal to one, log-utility, dominates the market and the other individual with IES further away from one is eliminated. In the long-run, only the individual with IES close or equal to one has an impact on asset prices. Thus, long-run asset prices reflect only the preference parameters of the surviving individual. On the other hand, asset prices are characterized by extreme dynamics if the economy is populated by myopic individuals only, who have perfect foresight about equilibrium asset prices. We show that even though the dividends of the long-lived asset are constant over time, there exist asset price dynamics that resemble an everexpanding asset price bubble. Lastly, we introduce debt in the initial set-up by allowing individuals to hold liquid and illiquid assets. This allows for the possibility of bankruptcies. I am indebted to Herakles Polemarchakis and Andres Carvajal for their guidance and support throughout my studies. I have benefited from discussions with Pablo Beker which has made many interesting suggestions. 1 1

Abstract What is the characterization of asset prices and investor’s behavior under time-inconsistent preferences? This paper investigates the characterization of financial market equilibrium when time-inconsistency takes the form of myopia or hyperbolic discounting (HD). We consider an infinite horizon economy under certainty with two heterogeneous CRRA individuals, one good and one long-lived asset. The question of survival in the market arises when individuals are HD maximizers or myopic with wrong expectations about equilibrium asset prices. We provide sufficient conditions such that more myopic individuals dominate over less myopic ones and also sophisticated HD maximizers with intertemporal elasticity of substitution (IES) equal to one, log-utilities, dominate over HD maximizers with IES higher than one. Thus, individuals that vanish in the long-run will not have an impact on asset prices. On the other hand, asset prices are characterized by extreme dynamics if the economy is populated by myopic individuals only, who have perfect foresight about equilibrium asset prices. We show that even though the dividends of the long-lived asset are constant over time, there exist asset price dynamics that resemble an ever-expanding asset price bubble. Lastly, we introduce debt in the initial set-up by allowing individuals to hold liquid and illiquid assets. This allows for the possibility of bankruptcies. I am indebted to Herakles Polemarchakis and Andres Carvajal for their guidance and support throughout my studies. I have benefited from discussions with Pablo Beker who has made many interesting suggestions. 1 1