Finance Applications of Game Theory

Abstract

: Traditional finance theory based on the assumptions of symmetric information and perfect and competitive markets has provided many important insights. These include the Modigliani and Miller Theorems, the CAPM, the Efficient Markets Hypothesis and continuous time finance. However, many empirical phenomena are difficult to reconcile with this traditional framework. Game theoretic techniques have allowed insights into a number of these. Many puzzles remain. This paper argues that recent advances in game theory concerned with higher order beliefs, informational cascades and heterogeneous prior beliefs have the potential to provide insights into some of these remaining puzzles. 1 1. Introduction Finance is concerned with how the savings of investors are allocated through financial markets and intermediaries to firms, which use them to fund their activities. Finance can be broadly divided into two fields. The first is asset pricing, which is concerned with the decisions of investors. ...

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