Finance Applications of Game Theory

Traditional finance theory based on the assumptions of symmetric information and perfect and competitive markets has provided many important insights. These include the Modigliani and Miller Theorems, the CAPM, the Efficient Markets Hypothesis and continuous time finance. However, many empirical phenomena are difficult to reconcile with this traditional framework. Game theoretic techniques have allowed insights into a number of these. Many puzzles remain. This paper argues that recent advances in game theory concerned with higher order beliefs, informational cascades and heterogeneous prior beliefs have the potential to provide insights into some of these remaining puzzles. _________________ Prepared for Advances in Business Applications of Game Theory edited by Kalyan Chatterjee and William F. Samuelson. We are grateful to Kalyan Chatterjee, Armando Gomes, Hyun Song Shin, Bilge Yilmaz and particularly to an anonymous referee for helpful comments and suggestions. The first author thanks the Wharton Financial Institutions Center for support.