Internal rationality, imperfect market knowledge and asset prices

We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are ‘internally rational’, i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be ‘externally rational’, i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors? expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents? market knowledge.     

A portfolio choice model with utility from anticipation of future consumption and stock market mean reversion

This paper studies a consumption and portfolio choice problem of a long-lived investor who derives pleasure not only from current consumption, but also from the contemplation of future consumption. The model assumes that all effects of future consumption on current well being are assumed to enter through a single variable—namely, the “stock of future consumption”—analogously to habit-formation models. The main implications of the model concern the incentives for savings, and the fundamental sources of risk in financial markets. It is shown that, when the stock market exhibits mean reversion, deriving utility from anticipation of future consumption has a tremendous effect on portfolio choice. In particular, mean allocation to stocks is much lower under the proposed preferences relative to the standard preferences, especially for high risk averse investors.     

Art market inefficiency

Art is often used as an investment vehicle. Given the importance of market efficiency in finance, we use a large auction-based index to test whether the art market is weakly efficient. Evidence reveals that returns on artworks exhibit high positive auto-correlation. We attribute this result to price truncation resulting from unobservable reserve prices in auctions. We conclude that the art market is not efficient, mainly because price formation is opaque to outsiders who lack information on unsold artworks.     

Manipulating market sentiment

We analyze a simple model of an asset market, in which a large rational trader interacts with “noise speculators” who seek short-run speculative gains, and become active following a prolonged episode of mispricing relative to the asset’s fundamental value. The model gives rise to price patterns such as bubble dynamics, positive short-run correlation and vanishing long-run correlation of price deviations from the fundamental value. We argue that this example model sheds light on the question as to whether rational speculators abet or curb price fluctuations.     

Mergers and the market for organization capital

In this paper, mergers are an equilibrium outcome in which acquirers “marry” targets so as to gain access to their organization capital. Firms with lower learning costs about the new technology are not necessarily those that manage it best once it is mature. Since there are gains from trade, a market for organization capital can arise through mergers. This model generates a merger wave after a shock to technology and is consistent with several other stylized facts on mergers documented in the literature.     

Financial market integration: Theory and empirical results

In this article, we introduce a new theoretical international asset pricing model which accounts for partial financial market segmentation. We show that if some investors do not hold all international assets because of implicit and/or explicit segmentation factors, the world market portfolio is not efficient and the classic ICAPM must be augmented by a new factor reflecting the local risk undiversifiable internationally. We test this model empirically for a sample of emerging markets. Our findings show that the degree of market integration is time-varying and that the premium associated with the domestic risk factors is the most important component of the total risk premium. However, our results also show that most of the emerging markets we study have become more integrated in the end of our sample period as a result of liberalization and reforms.     

Loss aversion and market crashes

This study proposes a rational expectation equilibrium model of stock market crashes with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable. The model predicts nonlinear market depth and the result that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results are consistent with the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements that are not driven by major news events but coupled with a spillover effect between unrelated markets.     

Volatility transmission to the fine wine market

The goal of this paper is to explore volatility transmission from various markets to the fine wine market. Knowledge of these channels for transmitting volatility to the wine market allows practitioners to anticipate the future volatility and the consequences of a shock on the wine market, to develop their investment strategy and diversify their risk. We especially analyse the impact of U.S. markets (i.e. art, commodities, credit, financial and real estate) during the 2007–2017 period. We shed additional light on how the volatility of the fine wine market varies during an extended period including a financial crisis. Our results indicate that, in the short-term, volatility is transmitted with a negative effect through the financial and commodity markets and with a positive effect through the art, residential real estate, and credit default markets. In the long-term, the wine market is impacted by all other markets. We show that correlations are time-varying.     

Information asymmetry,cluster trading,and market efficiency: Evidence from the Chinese stock market

This study investigates the effect of asymmetry information and illiquidity related to cluster trading on information integration efficiency in the Chinese stock market. The results show that information asymmetry and illiquidity related to cluster trading both negatively affect market efficiency in the Chinese stock market. While the effect of information asymmetry on market efficiency dominates in the informational period, the effect of illiquidity related to cluster trading dominates in other periods, when trading is less concentrated. Noise trading has a positive effect on market efficiency by greatly reducing the illiquidity related to cluster trading; however, its effect on information asymmetry is not significant. Our results provide insight into investors’ trading strategies.     

Estimating the portion of technical analysts in a market

This article presents structural estimates of the portion of technical analysts in six markets. I find that the portion of technical analysts in the U.S. equity market has been decreasing since the 1970s. A simple asset pricing model predicts that both risk and return are increasing in the portion of technical analysts. This prediction is confirmed across stock market indexes for six countries.     

The composition of capital inflows when emerging market firms face financing constraints

The composition of capital inflows to emerging market economies tends to follow a predictable dynamic pattern across the business cycle. In most emerging market economies, total inflows are pro-cyclical, with debt and portfolio equity flowing in first, followed later in the expansion by foreign direct investment (FDI). To understand the dynamic composition of these flows, we use a small open economy (SOE) framework to model the composition of capital inflows as the equilibrium outcome of emerging market firms' financing decisions. We show how costly external financing and FDI search costs generate a state contingent cost of financing such that the cheapest source of financing depends on the phase of the business cycle. In this manner, the financial frictions are able to explain the interaction between the types of flows and deliver a time-varying composition of flows, as well as other standard features of emerging market business cycles. If, as this work suggests, flows are an equilibrium outcome of firms' financing decisions, then volatility of capital inflows is not necessarily bad for an economy. Furthermore, using capital controls to shut down one type of flow and encourage another is certain to have both short- and long-run welfare implications.     

Testing the hypothesis of market efficiency in the Taiwan-US forward exchange market since 1990

This article examines the applicability of the hypothesis of market efficiency in Taiwan's foreign exchange market using daily data. Instead of linear regression-based models, we consider the possibility that the true data generating process may come from two different distributions, and we employ the Markov Switching approach to analyse this. From the results of the two-state Markov Switching model, we define State 1 as the efficient state and State 2 as the inefficient one. Only the 30-day forward rate is able to differentiate between the two states. Based on the unconditional probabilities from the Markov switching model, we also find that the 30-day forward rate has a 70% probability in the efficient state, which indicates that 70% of all speculators fully extract information when predicting future spot rates, while 30% of all investors do not.     

Does risk aversion explain behavior in a lemon market?

Siegenthaler proposes an ingenious solution to the lemon market adverse selection problem. He incorporates ‘‘cheap talk’’ in which sellers send out costless and nonbinding messages informing potential buyers of the quality of their goods; these messages could be true or false. This segments the market into several submarkets. Potential buyers need to decide which submarket to enter and what price to bid for the goods. Sellers then decide whether to accept the bid or not. He experimentally tests his model and finds that the comparative static results align with his theory, although the data do not exactly fit the model. Indeed, he does not fit the model to the data. His theory assumes risk-neutral decision-makers (DMs). Two reasons why the fit is not perfect may be that the DMs are not risk neutral and not perfectly rational. In this note, we report the results of fitting an asymmetric risk averse quantal response equilibrium (QRE) extension of his model to his data, and we find that the extension fits well. We show that the results are consistent with the market evidence and shed light on future research on lemon markets.     

Price manipulation in an experimental asset market

We analyze in the laboratory whether an uninformed trader is able to manipulate the price of a financial asset by comparing the results of two experimental treatments. In the benchmark treatment, 12 subjects trade a common value asset that takes either a high or a low value. Only three subjects know the actual value of the asset while the market is open for trading. The manipulation treatment is identical to the benchmark treatment apart from the fact that we introduce a computer program as an additional uninformed trader. This robot buys a fixed number of shares in the beginning of a trading period and sells them again afterwards. Our main result shows that the last contract price is significantly higher in the manipulation treatment if the asset takes a low value and that private information is very well disseminated by both markets if the value of the asset is high. Finally, even though this simple manipulation program loses money on average, it is profitable in some instances.     

Modelling price competition across many markets (An application to the Spanish loans market)

The purpose of this work is the structural modelling of price competition in a product-differentiated industry in which many firms of varying size compete across many independent small markets, with the target of identifying price behaviour. We apply it to model competition among the more than 79 banks that were active in the Spanish loans market during the period 1983-1991, using micropanel data. A model in which national banks (as opposed to regional and local banks) fully internalize their cross-rate effects in pricing is selected as the model that best fits the data. Our framework allows us to estimate the dead-weight loss due to market power, and to decompose it assessing the part attributable to price coordination.     

Deregulation, market power and risk behaviour in Spanish banks

This paper provides empirical evidence on the effects of regulatory changes in the market power of Spanish banks. It also analyses the response of banks, in terms of risk-taking behaviour, as a result of a reduction in economic profits. We find that liberalisation measures have increased competition and eroded banks’ market power. We observe that banks with lower charter values tend to have lower equity-assets ratios (lower solvency) and to experience higher credit risk. The last evidence is new in the literature and calls for strengthening regulatory concerns about credit risk management by banks in situations of increased competition.     

Oil price shocks and stock market activities: Evidence from oil-importing and oil-exporting countries

While the relationship between oil prices and stock markets is of great interest to economists, previous studies do not differentiate oil-exporting countries from oil-importing countries when they investigate the effects of oil price shocks on stock market returns. In this paper, we address this limitation using a structural VAR analysis. Our main findings can be summarized as follows: First, the magnitude, duration, and even direction of response by stock market in a country to oil price shocks highly depend on whether the country is a net importer or exporter in the world oil market, and whether changes in oil price are driven by supply or aggregate demand. Second, the relative contribution of each type of oil price shocks depends on the level of importance of oil to national economy, as well as the net position in oil market and the driving forces of oil price changes. Third, the effects of aggregate demand uncertainty on stock markets in oil-exporting countries are much stronger and more persistent than in oil-importing countries. Finally, positive aggregate and precautionary demand shocks are shown to result in a higher degree of co-movement among the stock markets in oil-exporting countries, but not among those in oil-importing countries.     

Regulation and the market for checks

This paper presents an analysis of the market for checks using the monopoly problem as an approximation. The need for such an analysis arises due to the following policy proposal: from time to time, the Turkish government considers increasing the lump-sum amount that drawee banks are legally responsible to pay per bad check. The purpose of this proposal is to ease out firms' liquidity needs especially during recessions. We show that banks will tend to restrict the quantity of checks as a response to such a policy action. We report that a percentage point increase in banks' obligation per bad check could lead up to a 1.7% decline in the total supply of checks on the margin. This means that such a policy change may harm the real economy rather than providing support. We establish that the extent of the monopoly distortion depends on three main factors: (i) the elasticity of demand for checks, (ii) how fast the fraction of bad checks increases with the total supply of checks, and (iii) the degree of preference heterogeneity.     

Analysis of the supply and demand in the TFT–LCD market

A methodology for the analysis of the supply and demand in the Thin-Film Transitor (TFT)-liquid crystal display (LCD) market in 2004 is proposed. The quarterly history supply and demand data are collected from 63 factories in Taiwan, Korea, Japan, and China during 2000–2003. This method takes into the account supply, demand, and differences between supply/demand. For the supply, a heuristic approach is used to forecast the future supply. For the demand, a transfer function model is used to forecast the future demand. The difference analysis of the supply and demand shows that it can predict whether or not there appears to be a shortage in the market of 2004. In addition, three important managerial implications such as pricing strategy, product-mix decision, and customer's priority are discussed in this paper.     

Information sharing and lending market competition with switching costs and poaching

We analyze information sharing with repeated banking competition. In the presence of switching costs we find that information sharing renders poaching more profitable in future rounds of competition, since the poaching activities can be targeted towards (more) creditworthy borrowers. We find that information sharing reduces relationship benefits, and, therefore relaxes competition for initial market shares. Information sharing introduces a welfare tradeoff by promoting equilibrium profits at the expense of talented entrepreneurs whenever market power persists in credit market, whereas it is a matter of indifference without market power. Thus information sharing may induce exclusion of creditworthy borrowers from credit markets.