Working Paper: NBER ID: w15189
Authors: Leonid Kogan; Stephen Ross; Jiang Wang; Mark M. Westerfield
Abstract: The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders' consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.
Keywords: Market Selection; Forecasting; Asset Pricing
JEL Codes: D51; D53; G1; G11; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| forecast errors (C53) | survival (C41) |
| risk attitudes (D81) | survival (C41) |
| bounded relative risk aversion (D11) | agents with accurate forecasts dominate the market (G17) |
| forecast errors diminish more slowly than growth rate of risk aversion (D15) | agents with less accurate forecasts maintain nontrivial consumption share (E27) |
| agents with less accurate forecasts (C53) | affect prices (E30) |
| volatility of consumption shares (E21) | price impact (G14) |
| survival (C41) | price impact (G14) |
| agents with inferior forecasts (C53) | do not survive (Y40) |
| agents with inferior forecasts (C53) | do not impact prices in the long run (F69) |
| price impact (G14) | determined by volatility of consumption shares (E20) |