Bounded rationality, asymmetric information and mispricing in financial markets

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.