The tradeoff between risk sharing and information production in financial markets

The production of information in financial markets is limited by the extent of risk sharing. The wider a stock's investor base, the smaller the risk borne by each shareholder and the less valuable information. A firm which expands its investor base without raising capital affects its information environment through three channels: (i) it induces incumbent shareholders to reduce their research effort as a result of improved risk sharing, (ii) it attracts potentially informed investors, and (iii) it may modify the composition of the base in terms of risk tolerance or liquidity trading. Implications for individual firms and the market as a whole are derived.     

Matching markets with adverse selection

This paper considers a market with adverse selection in the spirit of Rothschild and Stiglitz (Quart. J. Econ. 90 (1976) 629). The major departure from existing approaches is that we model a decentralized market that is open-ended and constantly refilled by new participants, e.g., by new workers and firms in the case of a labor market. The major novelty of this approach is that the distribution of types in the market becomes an endogenous variable, which is jointly determined with equilibrium contracts. As frictions become small, we show that the least-cost separating contracts are always supported as an equilibrium outcome, regardless of the distribution of types among entrants. Moreover, we derive conditions under which this outcome is also unique.     

Germany's New Insider Law: The Empirical Evidence after the First Year

Abstract. This paper investigates insider trading activities in German stocks during the first year following implementation of the new Insider Law on 1 July 2002. It can be observed that insiders act as contrarian investors. They buy stocks after prices have fallen and sell stocks after prices have risen. In general, insider trades are very profitable. A typical stock purchased by an insider yields an abnormal return of almost 3 per cent during the 25 days following the transaction. In contrast, a typical stock that has been sold by insiders achieves an abnormal return of nearly −3 per cent over the same time period. Outsiders who copy the transactions of insiders can achieve nearly the same abnormal returns. Abnormal returns remain substantial even after transaction costs. The results suggest that prices of stocks in which insiders trade do not seem to be semi-strong efficient.     

Incentive compatibility and differentiability: New results and classic applications

We provide several generalizations of Mailath?s (1987) [9] result that in games of asymmetric information with a continuum of types incentive compatibility plus separation implies differentiability of the informed agent?s strategy. The new results extend the theory to classic models in finance such as Leland and Pyle (1977) [8], Glosten (1989) [4], and DeMarzo and Duffie (1999) [3], that were not previously covered.     

The dynamics of efficient asset trading with heterogeneous beliefs

This paper analyzes the dynamic properties of portfolios that sustain dynamically complete markets equilibrium when agents have heterogeneous priors. We argue that the conventional wisdom that belief heterogeneity generates continuous trade and significant fluctuations in individual portfolios may be correct but it needs some qualifications. We consider an infinite horizon stochastic endowment economy populated by many Bayesian agents with heterogeneous priors over the stochastic process of the states of nature. Our approach hinges on studying the portfolios that decentralize Pareto optimal allocations. Since these allocations are typically history dependent, we propose a methodology to provide a complete recursive characterization when agents believe that the process of states of nature is i.i.d. but disagree about the probability of the states. We show that even though heterogeneous priors within that class can indeed generate genuine changes in the portfolios of any dynamically complete markets equilibrium, these changes vanish with probability one if the true process consists of i.i.d. draws from a common distribution and the support of some agent's prior belief contains the true distribution. Finally, we provide examples in which asset trading does not vanish because either (i) no agent learns the true conditional probability of the states or (ii) some agent does not know the true process generating the data is i.i.d.     

Intertemporal pricing in markets with differential information

Summary This paper provides a theory of intertemporal pricing in a small market with differential information about the realizations of a stochastic process which determines demand. We study the sequential equilibria in stationary strategies of the stochastic game between a seller and buyer. The seller has zero cost of producing one unit of a non-durable good in all market periods. The buyer's value for the good is a random variable governed by a simple Markov process. At the beginning of each period the unit's value is determined by nature and is privately revealed to the buyer. The seller posts a single price offer each period, which the buyer either accepts or rejects. Only two types of price paths emerge in equilibrium: either prices are constant, or they have persistent cycles between a low and a high value. In both cases, however, prices are sticky in the sense that changes in price are less frequent than changes in the economy's fundamentals.We thank John Rust and Asher Wolinsky for helpful comments. We also gratefully acknowledge financial support from NSF grant SES 89-09242.     

The relative contributions of private information sharing and public information releases to information aggregation

We calculate learning rates when agents are informed through public and private observation of other agents' actions. We characterize the evolution of the distribution of posterior beliefs. If the private learning channel is present, convergence of the distribution of beliefs to the perfect-information limit is exponential at a rate equal to the sum of the mean arrival rate of public information and the mean rate at which individual agents are randomly matched with other agents. If, however, there is no private information sharing, then convergence is exponential at a rate strictly lower than the mean arrival rate of public information.     

Implementing efficient allocations in a model of financial intermediation

In a finite-trader version of the Diamond and Dybvig (J. Polit. Econ. 91 (1983) 401) model, the ex ante efficient allocation is implementable by a direct mechanism (i.e., each trader announces the type of his own ex post preference) in which truthful revelation is the strictly dominant strategy for each trader. When the model is modified by formalizing the sequential-service constraint (cf. Wallace (Fed. Reserve Bank Minneapolis Quart. Rev. 12 (1988) 3)), the truth-telling equilibrium implements the symmetric, ex ante efficient allocation with respect to iterated elimination of strictly dominated strategies.     

Smart fund managers? Stupid money?

Abstract .  We develop a model of mutual fund manager investment decisions near the end of quarters. We show that when investors reward better performing funds with higher cash flows, near quarter-ends a mutual fund manager has an incentive to distort new investment toward stocks in which his fund holds a large existing position. The short-term price impact of these trades increase the fund's reported returns. Higher returns are rewarded by greater subsequent fund inflows which, in turn, allow for more investment distortion the next quarter. Because the price impact of trades is short term, each subsequent quarter begins with a larger return deficit. Eventually, the deficit cannot be overcome. Thus, our model leads to the empirically observed short-run persistence and long-run reversal in fund performance. In doing so, our model provides a consistent explanation of many other seemingly contradictory empirical features of mutual fund performance.     

Herding in delegated portfolio management: When is comparative performance information desirable?

We address the issue of investors’ asset allocation decisions when portfolio management is delegated to an agent. Contrary to predictions from traditional financial theory, it is shown that investors may not induce their manager to allocate funds to the asset with the highest return. Instead they may herd in their asset allocation decision and induce trade in a particular asset, because another manager is trading in it and despite the presence of a more profitable alternative. Doing so allows investors to write an efficiency-improving relative-performance contract. On the other hand, herding leads investors to design wage contracts strategically, resulting in more aggressive and thus less profitable trade in equilibrium. We show that herding occurs, when the cost of information is high, information precision is low and when managers are sufficiently risk averse. Moreover, when investors can decide whether or not to disclose information about their manager's performance, they will not do so.     

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.     

The communication requirements of social choice rules and supporting budget sets

The paper examines the communication requirements of social choice rules when the (sincere) agents privately know their preferences. It shows that for a large class of choice rules, any minimally informative way to verify that a given alternative is in the choice rule is by verifying a “budget equilibrium”, i.e., that the alternative is optimal to each agent within a “budget set” given to him. Therefore, any communication mechanism realizing the choice rule must find a supporting budget equilibrium. We characterize the class of choice rules that have this property. Furthermore, for any rule from the class, we characterize the minimally informative messages (budget equilibria) verifying it. This characterization is used to identify the amount of communication needed to realize a choice rule, measured with the number of transmitted bits or real variables. Applications include efficiency in convex economies, exact or approximate surplus maximization in combinatorial auctions, the core in indivisible-good economies, and stable many-to-one matchings.     

Anti-herding and strategic consultation

In this paper I analyze how careerist decision makers aggregate and use information provided by others. I find that decision makers who are motivated by reputation concerns tend to ‘anti-herding’, i.e., they excessively contradict public information such as the prior or others’ recommendations. I also find that some decision makers may deliberately act unilaterally and not consult advisers although advice is costless. Moreover, advisers to the decision maker may not report their information truthfully. Even if the advisers care only about the outcome, they bias their recommendation since they anticipate inefficient anti-herding behavior by the decision maker.     

From posteriors to priors via cycles

We present new necessary and sufficient conditions for checking if a set of players' posteriors may come from a common prior. A simple diagrammatic device calculates the join and meet of players' knowledge partitions. Each cycle in the diagram has a corresponding cycle equation. Posteriors are consistent with a common prior if and only if all cycle equations are satisfied. We prove that in games of two players, where the join partition has only singletons, a common prior exists if each player's distribution of beliefs over the elements of her opponent's partition is independent of her own private information.     

Partnerships, lemons, and efficient trade

We analyze the possibility of efficient trade with informationally interdependent valuations and with a dispersed ownership. A main role is played by the effects of adverse selection on incentive payments and budget constraints. Variations in the degree of interdependence directly influence the incentive payments and ultimately lead to a tightening or relaxation of the budget constraint, thus affecting the ability to achieve efficient trade. We derive precise possibility conditions for efficient trade, and we offer a framework in which the interplay of insights previously obtained by Akerlof (Quart. J. Econom. 89 (1970) 488), Myerson and Satterthwaite (J. Econom. Theory 28 (1983) 265), and Cramton et al. (Econometrica 55 (1987) 615) can be analyzed. In addition, we discuss to what extent possibility results previously obtained for private values environments can be generalized.     

Financial opening, deposit insurance, and risk in a model of banking competition

We study the impact of competition on banks’ risk-taking behavior under different assumptions about deposit insurance and the dissemination of information. While financial opening increases banks’ riskiness, a risk-based deposit insurance or, alternatively, the public disclosure of financial information, are likely to mitigate this effect. Moreover, the limiting cases of uninsured but fully informed depositors, and risk-based full deposit insurance, yield the same equilibrium risk level. Although the welfare consequences of increased competition depend on its impact on risk, financial opening unambiguously improves welfare as we approach the limiting cases.     

Matching with noise and the acceptance curse

This paper explores matching with both search and information frictions. Specifically, everyone observes only a noisy signal of the true type of any potential mate. In this context, matching decisions must incorporate not only information about a partner's attribute conveyed by the noisy signal, but also—as in the winner's curse in auction theory—information about a partner's type contained in his or her acceptance decision.We show that there exists an equilibrium exhibiting a stochastic positive assorting of types, generalizing [Becker, J. Polit. Economy 81 (1973) 813-846]. In equilibrium, selection is adverse: being accepted reduces an agent's estimate of a potential partner's type, a phenomenon that we call the acceptance curse effect.     

A Walrasian Rubinstein and Wolinsky model

We provide a full dynamic analysis of a continuous-time variant of Rubinstein and Wolinsky (1985) matching and bargaining model with unbalanced flows of buyers and sellers. The focus is on the price limit as the frictions of search are removed. It is found that a necessary and sufficient condition for the limit price to be Walrasian at all times is the alignment of the initial buyer and seller stocks with the flows.     

THIRD PARTIES, INFORMATION DISCLOSURE AND MONITORING INCENTIVES

Within an incomplete contract setting, the paper analyses the role of third parties in ameliorating incentive problems arising in the context of financial contracts with costly verification and lender's bargaining power. Contrary to the findings of the bilateral lender–borrower relationship, characterised by no information revelation and possibly a breakdown of the market, it is shown that, in the presence of third parties, an optimal contract exists featuring partial information revelation and random monitoring. The importance of third parties is therefore not limited to improving efficiency, as it is when the contract offer comes from the informed party, but to ensure project realisation, and thus to ensure that the surplus that can arise from the project does not get lost.     

Contractual distortions in a market with frictions

This paper analyses contract design in a decentralized market environment with frictions. While principals (e.g., firms) have all contractual power, their market power is constrained as agents (e.g., workers) can choose to wait and search for better offers. We find that results depend crucially on how market frictions affect agents’ utilities. With type-independent costs of search and waiting, equilibrium contracts are always first-best. If agents are impatient and discount future payoffs, however, distortions vanish only gradually. In the latter case, we also characterize equilibrium offers and show that the market exhibits two types of externalities, both of which are absent in the case of type-independent costs of search.