Working Paper: NBER ID: w18647
Authors: Roger EA Farmer; Carine Nourry; Alain Venditti
Abstract: 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 in completeness 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.
Keywords: Inefficient Markets; Stochastic Discount Factor; Pareto Efficiency
JEL Codes: E44; G01; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Modified stochastic representative agent model (E13) | Invalidate assumption of efficient risk allocation in competitive financial markets (G19) |
| Demographic factors (J11) | Market inefficiencies (G14) |
| Failure of complete financial markets to deliver socially efficient allocations (D52) | Market inefficiencies (G14) |
| Inability of agents to insure against risks occurring before birth (G22) | Failure of complete financial markets to deliver socially efficient allocations (D52) |
| Modified stochastic representative agent model (E13) | Replicate observed volatility of stochastic discount factor (C59) |