Labor income,borrowing constraints,and equilibrium asset prices

Summary We develop a duality approach to study an individual's optimal consumption and portfolio policy when the individual has limited opportunities to borrow against future labor income and cannot totally insure the risk of income fluctuations. The individual's intertemporal consumption and portfolio problem is cast in a continuous-time setting under uncertainty. We transform the individual's intertemporal problem into a dual shadow prices problem that solves the shadow prices for the individual's optimal consumption plan or equivalently the individual's intertemporal marginal rates of substitution. We show that the shadow prices process can be expressed as a product of a martingale and a decreasing process (normalized by the bond price). The existence of an optimal solution to the individual's intertemporal consumption and portfolio problem is established via duality. The duality approach also allows us to characterize in a sample way the individual's optimal consumption and portfolio policy in the presence of labor income and borrowing constraints. Equilibrium implications of borrowing constraints on asset prices are also discussed in the paper.This is a revised version of an earlier paper, entitled Consumption and Portfolio Decisions with Labor Income and Borrowing Constraints. We thank George Constandinides, Ayman Hindy, and Chi-fu Huang for helpful comments. We also thank two anonymous referees for their helpful comments and suggestions. Financial support from the Batterymarch Fellowship Program (for Hua He) is gratefully acknowledged.     

HAVE INSTITUTIONAL INVESTORS DESTABILIZED EMERGING MARKETS?

In the past few years, there has been a large increase in portfolio capital flows into emerging markets, mostly fueled by mutual funds and other institutional investors. Based on a simple variance ratio test, this paper finds that emerging stock markets as a group experienced a sharp increase in autocorrelation in total returns at a time when institutional investors began to expand significantly their holdings in these markets. These results are consistent with the view that institutional investor sentiment toward emerging markets as an asset class can at times play a critical role in determining asset prices, with shifts in sentiment resulting in periods of bubble-like booms and busts and asset price overshooting.     

Investor sentiment,information and asset pricing model

We present an asset pricing model with investor sentiment and information, which shows that the investor sentiment has a systematic and significant impact on the asset price. The equilibrium price's rational term drives the asset price to the rational, and the sentiment term leads to the asset price deviating from it. In our model, the proportion of sentiment investors and the information quality could amplify the sentiment shock on the asset price. Finally, the information is fully incorporated into prices when sentiment investors learn from prices. The model could offer a partial explanation of some financial anomalies: price bubbles, high volatility, asset prices' momentum effect and reversal effect.     

No-arbitrage, state prices and trade in thin financial markets

We examine how non-competitiveness in financial markets affects the choice of asset portfolios and the determination of equilibrium prices. In our model, potential arbitrage is conducted by a few highly specialized institutional investors who recognize and estimate the impact of their trades on financial prices. We apply a model of economic equilibrium, based on Weretka (, 2007a), in which price effects are determined endogenously as part of the equilibrium concept. For the case in which markets allow for perfect insurance, we argue that the principle of no-arbitrage asset pricing is consistent with non-competitive behavior of the arbitragers and extend the fundamental theorem of asset pricing to the non-competitive setting.     

Excess price volatility and financial innovation

Summary. In a three-period finite exchange economy with incomplete financial markets and retrading, we study the effects of the degree of incompleteness and of changes in the financial structure on asset price volatility. In what are essentially no aggregate risk economies, asset price volatility is a sunspot-like phenomenon. If markets are completed by financial innovation, asset price volatility reduction is generic. With aggregate risk, changes in the financial structure affect asset price volatility through a pecuniary externality. Financial innovation which decreases equilibrium price volatility can be crafted under conditions of sufficient market incompleteness. Numerical examples illustrate the role of risk aversion for volatility changes and show that, with or without aggregate risk, reducing the degree of incompleteness per se is not necessarily associated with a volatility reduction.Received: 10 October 2003, Revised: 3 June 2004, JEL Classification Numbers: C60, D52, G10. Correspondence to: Alessandro CitannaThis research project stems from and expands previous work circulated as Financial innovation and price volatility, GSIA Working Paper #1996-E30 and Controlling price volatility through financial innovation, Kellogg Working Paper #2002-1338. We thank Herakles Polemarchakis and Chris Telmer for their comments. We are grateful to an anonymous referee for careful reviews of earlier versions. The first author thanks also GSIA - Carnegie Mellon University for the kind hospitality during Fall 2002, when part of this project was completed.     

Overconfidence and Market Efficiency with Heterogeneous Agents

We study financial markets in which both rational and overconfident agents coexist and make endogenous information acquisition decisions. We demonstrate the following irrelevance result when a positive fraction of rational agents (endogenously) decides to become informed in equilibrium, prices are set as if all investors were rational, and as a consequence the overconfidence bias does not affect informational efficiency, price volatility, rational traders’ expected profits or their welfare. Intuitively, as overconfidence goes up, so does price informativeness, which makes rational agents cut their information acquisition activities, effectively undoing the standard effect of more aggressive trading by the overconfident. The main intuition of the paper, if not the irrelevance result, is shown to be robust to different model specifications.We would like to thank Alberto Bisin, Xavier Freixas, Ken French, Moshe Kim, Jose Marín, and Terrance Odean for comments on an early draft, as well as an anonymous referee and seminar participants at HEC Geneva, the 2004 EFA meetings, the 2004 European Econometric Society meetings and the 2005 SAET conference. Diego García and Branko Urošević gratefully acknowledge financial support by SECCF (Belgrade).     

Compensation schemes,liquidity provision,and asset prices: an experimental analysis

In an experimental setting in which investors can entrust their money to traders, we investigate how compensation schemes affect liquidity provision and asset prices, two outcomes that are important for financial stability. Compensation schemes can drive a wedge between how investors and traders value the asset. Limited liability makes traders value the asset more than investors. To limit losses, investors should thus restrict liquidity provision to force traders to trade at a lower price. By contrast, bonus caps make traders value the asset less than investors. This should encourage liquidity provision and increase prices. In contrast to these predictions, we find that under limited liability investors increase liquidity provision and asset price bubbles are larger. Bonus caps have no clear effect on liquidity provision and they fail to tame bubbles. Overall, giving traders skin in the game fosters financial stability.     

On the Non-Existence of Redundant Options

In a seminal paper, Ross (Q J Econ 90:75–89, 1976) shows that if security markets are resolving, then there exist (non-redundant) options that generate complete security markets. Complementing his work, Aliprantis and Tourky (2002) show that if security markets are strongly resolving and the number of primitive securities is less than half the number of states, then every option is non-redundant. Our paper extends Aliprantis and Tourky’s result to the case when their condition on the number of primitive securities is not imposed. Specifically, we show that if there exists no binary payoff vector in the asset span, then for each portfolio there exists a set of exercise prices of full measure such that any option on the portfolio with an exercise price in this set is non-redundant. Since the condition that there exists no binary payoff vector in the asset span holds generically, redundant options are thus rare. I am grateful to an anonymous referee for very helpful comments. Research support from the School of Business at The George Washington University is gratefully acknowledged     

Liquidity and asset prices in rational expectations equilibrium with ambiguous information

The quality of information in financial asset markets is often hard to estimate. Reminiscent of the famous Ellsberg paradox, investors may be unable to form a single probability belief about asset returns conditional on information signals and may act on the basis of ambiguous (or multiple) probability beliefs. This paper analyzes information transmission in asset markets when agents?? information is ambiguous. We consider a market with risk-averse informed investors, risk-neutral competitive arbitrageurs, and noisy supply of the risky asset, first studied by Vives (Rev Financ Stud 8:3?C40, 1995a, J Econ Theory 67:178?C204, 1995b) with unambiguous information. Ambiguous information gives rise to the possibility of illiquid market where arbitrageurs choose not to trade in a rational expectations equilibrium. When market is illiquid, small informational or supply shocks have relatively large effects on asset prices.     

Fundamentals, information, and international capital flows: A welfare analysis

In the recent discussion surrounding the design of a new international financial architecture, enhancing transparency has widely been proposed as a policy essential for increasing the efficiency of international capital markets. This paper uses a simple two-country (two-agent) general equilibrium model with incomplete markets and production to explore the welfare consequences of an increase in public information about country-specific fundamentals (increase in transparency). An improvement in the quality of information has two effects on the ex ante welfare of individual countries: A direct effect that increases the efficiency of global capital allocation and welfare, and an indirect general equilibrium effect that increases asset price volatility and may decrease welfare. When the degree of risk-aversion is low, at least one country will gain from an increase in information quality. If the degree of risk-aversion is high, then there are robust examples of economies for which an increase in information hurts all countries. The paper also discusses how certain institutional arrangements (international derivative markets, international agency) could ensure that all countries gain from better information by providing insurance against information-induced asset price risk.     

Information Markets and the Comovement of Asset Prices

Traditional asset pricing models predict that covariance between prices of different assets should be lower than what we observe in the data. This paper introduces markets for information that generate high price covariance within a rational expectations framework. When information is costly, rational investors only buy information about a subset of the assets. Because information production has high fixed costs, competitive producers charge more for low-demand information than for high-demand information. The low price of high-demand information makes investors want to purchase the same information that others are purchasing. When investors price assets using a common subset of information, news about one asset affects the other assets' prices; asset prices comove. The cross-sectional and time-series properties of comovement are consistent with this explanation.     

Portfolio choice, attention allocation, and price comovement

This paper models the attention allocation of portfolio investors. Investors choose the composition of their information subject to an information flow constraint. Given their expected investment strategy in the next period, which is to hold a diversified portfolio, in equilibrium investors choose to observe one linear combination of asset payoffs as a private signal. When investors use this private signal to update information about two assets, changes in one asset affect both asset prices and may lead to asset price comovement. The model also has implications for the transmission of volatility shocks between two assets.     

International asset prices and portfolio choices under Bayesian learning

We calculate equilibrium asset prices and portfolio choices from a two-country OLG international asset pricing model under the assumption that investors are on a Bayesian learning path. Investors from both countries receive identical information flows, but domestic investors start off with less precise priors concerning foreign fundamentals. Learning is shown to produce first-order effects on the properties of asset prices, in the form of increased equity returns, volatility clustering, and time-varying correlations across national stock markets. Moreover, on a learning path, estimation risk generates portfolio biases similar to those observed empirically, i.e. a strong preference towards domestic securities and excessive turnover in foreign securities. These findings are robust to changes in prior beliefs, the calibration of initial information asymmetries, and the parameterization of the model. We use real GDP data for the US and Europe to calibrate the model and show that in the event of a financial liberalization during the 1970s, high excess returns, time-varying volatility, substantial home bias, and excess turnover should have been observed.     

Macroeconomic Effects of Asset‐Price Shocks in a Globalized Financial Market

In this paper, I study a model in which shocks to asset prices affect the real sector of the economy through a credit channel. As financial markets become internationally integrated, the economy becomes less vulnerable to domestic asset‐price shocks, but more vulnerable to foreign asset‐price shocks. To the extent that monetary policy stabilization is feasible and desirable, the globalization of financial markets shifts the focus of monetary policy from domestic asset prices to worldwide asset prices.     

The possibility of informationally efficient markets

A rational expectations equilibrium with positive demand for financial information does exist under fully revealing asset price—contrary to a wide-held conjecture. Whereas a continuum of investors is inconsistent with fully revealing equilibrium, finitely many investors with average portfolios demand information in equilibrium if they can adjust portfolio size in an additive signal-return model. More information diminishes the expected excess return of a risky asset so that investors who only have a choice of portfolio composition or whose asset endowments strongly differ from the average portfolio are worse off. Under fully revealing price, information market equilibria both with and without information acquisition are Pareto efficient.     

Market equilibrium with heterogeneous recursive-utility-maximizing agents

Summary This paper considers a heterogeneous agent Lucas style exchange economy. For a class of recursive utility functions containing the standard additive expected utility functions, I demonstrate that there exist market equilibria characterized by stationary (ergodic) Markov processes for consumption, portfolio holdings, asset prices and the unobserved utilities. No assumptions about market completeness are made, and there are no restrictions on the underlying information filtration.Other contributions of this paper include: (i) an existence and uniqueness theorem of intertemporal utility for the general class of recursive generators; (ii) the optimum principle as well as its corresponding Euler equation derived for the agent's consumption and portfolio choice problem under recursive utility, and (iii) a single-agent equilibrium asset pricing formula which generalizes that of Epstein and Zin (1989).This paper is a part of my PhD dissertation at the University of Toronto. I would like to thank Larry Epstein for his enthusiastic supervision, helpful discussion and valuable comments. Thanks also to Tan Wang and especially Darrell Duffie for valuable comments.     

On non-ergodic asset prices

We investigate the asset prices dynamics and the long-run market shares of two competing financial mediators who are selected by consumers. We demonstrate that the social interaction among consumers constitutes an endogenous path-depending source of risk in a financial market. Depending on consumers’ evaluation of the mediator’s investment, asset prices may behave in a non-ergodic manner: the price process converges in distribution but the limiting distribution is not necessarily uniquely determined, its multiplicity being characterized by the multiplicity of possible long-run market shares. The convergence of the process is sensitive to initial conditions and depends on the history of noise-trader transactions. Long-run portfolio holdings may be in-efficient since investors holding mean-variance efficient portfolios may not be identified.     

The Effects of Subject Pool and Design Experience on Rationality in Experimental Asset Markets

Empirical evidence suggests that prices do not always reflect fundamental values and individual behavior is often inconsistent with rational expectations theory. We report the results of fourteen experimental asset markets designed to examine whether the interactive effect of subject pool and design experience (i.e., previous experience in a market under identical conditions) tempers price bubbles and improves forecasting ability. Our main findings are: 1) price run-ups are modest and dissipate quickly when traders are knowledgeable about financial markets and have participated in a previous market under identical conditions; 2) price bubbles moderate quickly when only a subset of traders are knowledgeable and experienced; 3) the heterogeneity of expectations about price changes is smaller in markets with knowledgeable and experienced traders, even if such traders only represent a subset of the market; and 4) individual forecasts of prices are not consistent with the predictions of the rational expectations model in any market, although absolute forecast errors are smaller for subjects who are knowledgeable of financial markets and for those subjects who have participated in a previous market. In sum, our findings suggest that markets populated by at least a subset of knowledgeable and experienced traders behave rationally, even though average individual behavior can be characterized as irrational.     

Inducing liquidity in thin financial markets through combined-value trading mechanisms

Asset pricing theory hypothesizes that investors are only interested in portfolios; individual securities are evaluated only in terms of their contribution to portfolio risk and return. Yet, standard financial market design is that of parallel, unconnected markets, whereby investors cannot submit orders in one market conditional on events in others. When markets are thin, this exposes them to substantial execution risk. Fear of ending up with unbalanced portfolios after trading may even keep investors from submitting orders, further eroding liquidity and the ability of markets to equilibrate. The suggested solution is a portfolio trading mechanism referred to as combined-value trading (CVT). Investors are allowed to submit orders for packages of securities and the system matches trades and computes prices by optimally combining portfolio orders in an open book. We study the performance of the CVT mechanism experimentally and compare it to the performance of parallel, unconnected double auctions in experiments with similar parametrization and either a similar number of subjects or substantially thicker markets. We present evidence that our portfolio trading mechanism facilitates equilibration to the extent that the thicker markets do. Inspection of order submission and trade activity reveals that subjects manage to exploit the direct linkages between markets enabled by the CVT system.     

Beauty contest,bounded rationality,and sentiment pricing dynamics

We present a dynamic asset pricing model that incorporates investor sentiment, bounded rationality and higher-order expectations to study how these factors affect asset pricing equilibrium. In the model, we utilize a two-period trading market and investors make decisions based on the heterogeneous expectations principle and the “sparsity-based bounded rational” sentiment. We find that bounded rationality results in mispricing and reduces it in next period. Investor sentiment produces more significant effects than private signals, optimistic investor sentiment increases hedging demand, thus causing prices to soar. Higher-order investors are more rational and attentive to the strategies of other participants rather than private signals. This model also derives the dampening effect of higher-order expectations to price volatility and the heterogeneity expectation depicts inconsistent investor behavior in financial markets. In the model, investors' expectations about future price is distorted by their sentiment and bounded rationality, so they obtain a biased mean from the signal extraction.