Skip to main content
SpringerLink
Log in

Bounded rationality, asymmetric information and mispricing in financial markets

  • Research Article
  • Published:
Economic Theory Aims and scope Submit manuscript

Abstract

This paper proposes an asset pricing model with heterogeneous and boundedly rational agents. It shows a way how the market aggregates fundamental information and behavioral information into prices. Asset is likely to be mispriced due to the asymmetric information. The model incorporates a variety of behavioral factors, such as risk preference, investor rationality, disagreement on fundamental value and market liquidity. These factors have substantial impacts on both the equilibrium price and its stability conditions. As the findings show, the equilibrium price tends to reflect the information of the group which has low degree of rationality and high level of risk appetite. The simulations mimic the features observed in reality, such as periodic movements, chaotic dynamics and clustered volatility. The results provide potential explanations for the complex phenomena in financial markets.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Ackert, L., Deaves, R.: Behavioral Finance: Psychology, Decision-Making, and Markets. South-Western Cengage Learning, Mason (2010)

    Google Scholar 

  • Amir, R., Belkov, S., Evstigneev, I.V., Hens, T.: An evolutionary finance model with short selling and endogenous asset supply. Econ. Theory (2020). https://doi.org/10.1007/s00199-020-01269-x

    Article  Google Scholar 

  • Bao, T., Duffy, J.: Signal extraction: experimental evidence. UCI Working Paper (2020)

  • Barberis, N.: Psychology-Based Models of Asset Prices and Trading Volume. Social Science Electronic Publishing, Rochester (2018)

    Google Scholar 

  • Barberis, N., Thaler, R.: Chapter 18 a survey of behavioral finance. Handb. Econ. Finance 1(03), 1053–1128 (2003)

    Article  Google Scholar 

  • Barberis, N., Shleifer, A., Vishny, R.: A model of investor sentiment. J. Financ. Econ. 49(3), 307–343 (1998)

    Article  Google Scholar 

  • Barberis, N., Greenwood, R., Jin, L., Shleifer, A.: Extrapolation and bubbles. J. Financ. Econ. 129(2), 203–227 (2018)

    Article  Google Scholar 

  • Beja, A., Goldman, M.B.: On the dynamic behavior of prices in disequilibrium. J. Finance 35(2), 235–248 (1980)

    Article  Google Scholar 

  • Bianchi, M., Dana, R.A., Jouini, E.: Shareholder heterogeneity, asymmetric information, and the equilibrium manager. Econ. Theory (2021). https://doi.org/10.1007/s00199-021-01349-6

    Article  Google Scholar 

  • Brock, W.A., Hommes, C.H.: A rational route to randomness. Econometrica 65(5), 1059–1095 (1997)

    Article  Google Scholar 

  • Brock, W.A., Hommes, C.H.: Heterogeneous beliefs and routes to chaos in a simple asset pricing model. J. Econ. Dyn. Control 22, 1235–1274 (1998)

    Article  Google Scholar 

  • Brock, W.A., Hommes, C.H., Wagener, F.: More hedging instruments may destabilize markets. J. Econ. Dyn. Control 33, 1912–1928 (2009)

    Article  Google Scholar 

  • Cason, T.N., Reynolds, S.S.: Bounded rationality in laboratory bargaining with asymmetric information. Econ. Theory 25, 553–574 (2005). https://doi.org/10.1007/s00199-003-0464-2

    Article  Google Scholar 

  • Chen, Y., Su, X., Zhao, X.: Modeling bounded rationality in capacity allocation games with the quantal response equilibrium. Manag. Sci. 58, 1952–1962 (2012)

    Article  Google Scholar 

  • Chiarella, C., He, X.Z., Hommes, C.: A dynamic analysis of moving average rules. J. Econ. Dyn. Control 30(9), 1729–1753 (2006)

    Article  Google Scholar 

  • Chiarella, C., He, X.Z., Zheng, M.: An analysis of the effect of noise in a heterogeneous agent financial market model. J. Econ. Dyn. Control 35(1), 148–162 (2011)

    Article  Google Scholar 

  • Chiarella, C., He, X.Z., Zwinkels, R.C.J.: Heterogeneous expectations in asset pricing: empirical evidence from the S&P 500. J. Econ. Behav. Organ. 105(2), 1–16 (2014)

    Article  Google Scholar 

  • Coury, T., Sciubba, E.: Belief heterogeneity and survival in incomplete markets. Econ. Theory 49, 37–58 (2012). https://doi.org/10.1007/s00199-010-0531-4

    Article  Google Scholar 

  • Daniel, K., Hirshleifer, D., Subrahmanyam, A.: Investor psychology and security market under- and overreactions. J. Finance 53(6), 1839–1885 (1998)

    Article  Google Scholar 

  • Doukas, J.A., Pantzalis, C.: Arbitrage risk and stock mispricing. J. Financ. Quant. Anal. 45(4), 907–934 (2010)

    Article  Google Scholar 

  • Elaydi, S.: An Introduction to Difference Equations. Spinger, New York (2005)

    Google Scholar 

  • Epstein, L.G., Schneider, M.: Ambiguity, information quality, and asset pricing. J. Finance 63(1), 197–228 (2008)

    Article  Google Scholar 

  • García, D., Sangiorgi, F., Urosevic, B.: Overconfidence and market efficiency with heterogeneous agents. Econ. Theory 30(2), 313–336 (2007). https://doi.org/10.1007/s00199-005-0048-4

    Article  Google Scholar 

  • Golman, R.: Homogeneity bias in models of discrete choice with bounded rationality. J. Econ. Behav. Organ. 82(1), 1–11 (2012)

    Article  Google Scholar 

  • Gong, Q., Yang, Z.: Arbitrage, speculation and futures price fluctuations with boundedly rational and heterogeneous agents. J. Econ. Interact. Coord. 15(4), 763–791 (2020)

    Article  Google Scholar 

  • Grauwe, P.D., Grimaldi, M.: Exchange rate puzzles: a tale of switching attractors. Eur. Econ. Rev. 50(1), 1–33 (2006)

    Article  Google Scholar 

  • Grossman, S.J., Stiglitz, J.E.: On the impossibility of informationally efficient markets. Am. Econ. Rev. 70(3), 393–408 (1980)

    Google Scholar 

  • Hong, H., Stein, J.C.: A unified theory of underreaction, momentum trading, and overreaction in asset markets. J. Finance 54(6), 2143–2184 (1999)

    Article  Google Scholar 

  • Jacobs, H.: Market maturity and mispricing. J. Financ. Econ. 122(2), 270–287 (2016)

    Article  Google Scholar 

  • Kahneman, D.: Maps of bounded rationality: psychology for behavioral economics. Am. Econ. Rev. 93(5), 1449–1475 (2003)

    Article  Google Scholar 

  • Kelly, B., Ljungqvist, A.: Testing asymmetric-information asset pricing models. Rev. Financ. Stud. 25(5), 1366–1413 (2012)

    Article  Google Scholar 

  • Kirchler, M.: Underreaction to fundamental information and asymmetry in mispricing between bullish and bearish markets: an experimental study. J. Econ. Dyn. Control 33(2), 491–506 (2009)

    Article  Google Scholar 

  • Sadka, R., Scherbina, A.: Analyst disagreement, mispricing, and liquidity. J. Finance 62(5), 2367–2403 (2007)

    Article  Google Scholar 

  • Sciubba, E.: Asymmetric information and survival in financial markets. Econ. Theory 25, 353–379 (2005). https://doi.org/10.1007/s00199-003-0434-8

    Article  Google Scholar 

  • Serrano-Padial, R.: Naive traders and mispricing in prediction markets. J. Econ. Theory 147(5), 1882–1912 (2012)

    Article  Google Scholar 

  • Shleifer, A.: Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press, New York (2004)

    Google Scholar 

  • Spronk, R., Verschoor, W., Zwinkels, R.: Carry trade and foreign exchange rate puzzles. Eur. Econ. Rev. 60, 17–31 (2013)

    Article  Google Scholar 

  • Stambaugh, R.F., Yu, J., Yu, Y.: The short of it: investor sentiment and anomalies. J. Financ. Econ. 104(2), 288–302 (2012)

    Article  Google Scholar 

  • Stein, J.C.: Presidential address: sophisticated investors and market efficiency. J. Finance 64(4), 1517–1548 (2009)

    Article  Google Scholar 

  • Vayanos, D., Wang, J.: Liquidity and asset returns under asymmetric information and imperfect competition. Rev. Financ. Stud. 25(5), 1339–1365 (2012)

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Antai College of Economics and Management, Shanghai Jiao Tong University, Shanghai, 200030, China

    Qingbin Gong & Xundi Diao

Authors
  1. Qingbin Gong
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Xundi Diao
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Xundi Diao.

Additional information

Publisher's Note

Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

This work is supported by the National Natural Science Foundation of China (Nos. 71771147, 71790592) and the Graduate Innovation Foundation (No. CXJJ-2017-375) sponsored by Shanghai University of Finance and Economics. We are very grateful to Professor Zhe Yang for the helpful suggestions on this research. We also gratefully acknowledge the valuable comments and suggestions of two anonymous referees.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Gong, Q., Diao, X. Bounded rationality, asymmetric information and mispricing in financial markets. Econ Theory 74, 235–264 (2022). https://doi.org/10.1007/s00199-021-01366-5

Download citation

  • Received:

  • Accepted:

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s00199-021-01366-5

Keywords

Search

Navigation