DP9283 The Inefficient Markets Hypothesis: Why Financial Markets Do Not Work Well in the Real World

Author(s): Roger E A Farmer , Carine Nourry , Alain Venditti

Publication Date: January 2013

Keyword(s): asset pricing , efficient markets , excess volatility

JEL(s): E32 , E44 , G10 , G12 , G14

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP9283.asp

Existing literature continues to be unable to offer a convincing explanation for the volatility of the stochastic discount factor in real world data. Our work provides such an explanation. We do not rely on frictions, market incompleteness or transactions costs of any kind. Instead, we modify a simple stochastic representative agent model by allowing for birth and death and by allowing for heterogeneity in agents' discount factors. We show that these two minor and realistic changes to the timeless Arrow-Debreu paradigm are sufficient to invalidate the implication that competitive financial markets efficiently allocate risk. Our work demonstrates that financial markets, by their very nature, cannot be Pareto efficient, except by chance. Although individuals in our model are rational; markets are not.