In-depth investigation of market selection hypothesis legitimacy for financial markets
Most mainstream economic models and tools rely on the MSH. The EU-funded MSAEO (Market selection and aggregate economic outcomes) project studied the potential failure of the MSH, and whether being prone to failure is helpful in describing aggregate economic data. During the project’s first phase, the research team worked on a general framework where existing approaches that validate the MSH for complete financial markets can be confronted with the negative results that emerged from preliminary investigations. The framework enabled them to explain that models that support the MSH are dependent on a trade-off between intertemporal substitution rates and relative risk aversion that arise from the time separability of preferences. When preferences are non-time-separable, market selection failures occur even if some investors have perfect information on assets’ dividend processes and optimally allocate their consumption. Other critical assumptions include the following: agents have rational price expectations even when they ‘agree to disagree’ on the exogenous dividend process, and agent beliefs are exogenous and do not interact with each other through prices. Research on these assumptions reveals that coexistence of heterogeneous trading strategies is a generic outcome of the market selection process. The second phase concentrated on the explanation of positive returns autocorrelation at short horizons and negative returns autocorrelation at long horizons. While behavioural finance literature links the emergence of these empirical regularities to a representative investor’s cognitive biases in the processing of new information, MSAEO proposed a model where the coexistence of agents with different portfolios is the key factor. It showed that market sentiment emerges as opposed to behavioural finance investor sentiment. This phase also focused on the phenomenon of fire sales and their effect on overall market performance. The project team investigated the performance of portfolio strategies under liquidity shocks. MSAEO demonstrated that MSH fails generically, at least in exchange economies. It provided a better understanding of the forces that shape asset price dynamics in financial markets.
Keywords
Market selection hypothesis, financial markets, MSAEO, aggregate economic outcomes
