Internal rationality, imperfect market knowledge and asset prices


Adam, Klaus ; Marcet, Albert


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URL: https://ub-madoc.bib.uni-mannheim.de/30175
URN: urn:nbn:de:bsz:180-madoc-301759
Document Type: Working paper
Year of publication: 2010
Place of publication: Mannheim
Publication language: English
Institution: School of Law and Economics > VWL, Internat. Wirtschaftsbeziehungen (Adam)
Subject: 330 Economics
Classification: JEL: JEL Class. No.: G12, G14, D83, D84,
Keywords (English): learning, internal rationality, consumption based asset pricing
Abstract: We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are ´internally rational´, i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be ´externally rational´, i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors´ expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior a¤ects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents´ market knowledge.

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Adam, Klaus ; Marcet, Albert (2010) Internal rationality, imperfect market knowledge and asset prices. Open Access Mannheim [Working paper]
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