Market Selection and Asset Pricing for the Handbook of Financial Markets: Dynamics and Evolution

In this chapter we survey asset pricing in dynamic economies with heterogeneous, rational traders. By ‘rational’ we mean traders whose decisions can be described by preference maximization, where preferences are restricted to those which have an subjective expected utility (SEU) representation. By ’heterogeneous” we mean SEU traders with different and distinct payoff functions, discount factors and beliefs about future prices which are not necessarily correct. We examine whether the market favors traders with particular characteristics through the redistribution of wealth, and the implications of wealth redistribution for asset pricing. The arguments we discuss on the issues of market selection and asset pricing in this somewhat limited domain have a broader applicability. We discuss selection dynamics on Gilboa-Schmeidler preferences and on arbitrarily specified investment and savings rules to see what discipline, if any, the market wealth-redistribution dynamic brings to this environment. We also clarify the relationship between the competing claims of the market selection analysis and the noise trader literature.