Doctoral Dissertations

Date of Award

5-1992

Degree Type

Dissertation

Degree Name

Doctor of Philosophy

Major Professor

George C. Philippatos

Committee Members

Harold Black, Ronald Shrieves, Alan Schlottman

Abstract

The assumptions of homogeneous expectations and common knowledge beliefs in Finance are examined. Relaxation of the assumption of common knowledge with respect to all relevant events has a profound effect on financial equilibrium pricing models. Outcomes can no longer be considered as being exogenously determined. They depend on the evolution of beliefs which necessarily follows any exogenous shock associated with non common knowledge beliefs. The recognition of the dependence of outcomes on beliefs-which are more likely to be heterogeneous and non common knowledge immediately after the initial shock-leads to the following view of financial markets. Financial markets can be best described by a dynamic (i.e. disequilibrium) model of the belief adjustment process. If beliefs converge to a common limit, the price of the asset converges to an equilibrium price and a pricing equilibrium is reached. Pricing equilibria are topologically characterized and are found to be equivalent to common knowledge beliefs with respect to all relevant events. In addition, common knowledge beliefs are shown to imply homogeneous expectations. As a result, pricing equilibria are rational expectations equilibria, since beliefs at equilibrium are homogeneous and are confirmed by the relevant observables. A specific model of the belief adjustment process is derived in the form of a system of difference equations. Its attractors (i.e. equilibria) comply to the topological characterization of equilibrium, derived previously. Convergence of the process to equilibrium is not guaranteed but is favored by relatively uninhibited flow of information among investors. Further it is shown that the final equilibrium depends on both the initial disturbance and the belief adjustment process and as a result, financial assets do not have an intrinsic value determined exogenously. The value of a financial asset can only be specified within the particular market in which the asset is traded. Finally, the dynamic model developed is used in order to offer some possible explanations for "crashes" and "bubbles" the Weekend Effect and the Small Firm effect.

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