Trading mechanism selection with directed search when buyers are risk averse

We endogenize the trading mechanism selection in a model of directed search with risk averse buyers and show that the unique symmetric equilibrium entails all sellers using fixed price trading. Mechanisms that prescribe the sale price as a function of the realized demand (auctions, bargaining, discount pricing, etc.) expose buyers to the “price risk”, the uncertainty of not knowing how much to pay in advance. Fixed price trading eliminates the price risk, which is why risk averse customers accept paying more to shop at such stores.     

Search and endogenous concentration of liquidity in asset markets

We develop a search-based model of asset trading, in which investors of different horizons can invest in two assets with identical payoffs. The asset markets are partially segmented: buyers can search for only one asset, but can decide which one. We show the existence of a “clientele’’ equilibrium where all short-horizon investors search for the same asset. This asset has more buyers and sellers, lower search times, and trades at a higher price relative to its identical-payoff counterpart. The clientele equilibrium dominates the one where all investor types split equally across assets, implying that the concentration of liquidity is socially desirable.     

State-price densities under heterogeneous beliefs, the smile effect, and implied risk aversion

It has been widely noted in the empirical literature that state-price densities implicit in financial asset prices are not log-normal. This paper shows that this phenomenon can be caused by heterogeneity in investors’ beliefs. It derives the state-price density under heterogeneous beliefs in closed form and demonstrates that heterogeneous beliefs can give rise to multimodal state-price densities. Consequences for the “smile effect” in implied option volatility and for measures of risk aversion inferred from empirical state-price densities are discussed.     

Incomplete markets,liquidation risk,and the term structure of interest rates

We analyse the term structure of interest rates in a general equilibrium model with incomplete markets, borrowing constraint, and positive net supply of government bonds. Uninsured idiosyncratic shocks generate bond trades, while aggregate shocks cause fluctuations in the trading price of bonds. Long bonds command a “liquidation risk premium” over short bonds, because they may have to be liquidated before maturity – following a bad idiosyncratic shock – precisely when their resale value is low – due to the simultaneous occurrence of a bad aggregate shock. Our framework endogenously generates limited cross-sectional wealth heterogeneity among the agents (despite the presence of uninsured idiosyncratic shocks), which allows us to characterise analytically the shape of the entire yield curve, including the yields on bonds of arbitrarily long maturities. Agents? desire to hedge the idiosyncratic risk together with their fear of having to liquidate long bonds at unfavourable terms implies that a greater bond supply raises the level of the yield curve, while an increase in the relative supply of long bonds raises its slope.     

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.     

Winner's curse without overbidding

We report the results of a series of second-price auction experiments where each bidder's signal is given by a normally distributed value plus a normally distributed error. While bidders’ values differ in one treatment they are the same in another, which allows for a direct test of the “winner's curse” irrespective of confounding factors. Bidders may also fall prey to a “news curse” when they do not sufficiently take into account that signals and errors are correlated. We find that the effects of the winner's curse are mitigated by a news curse and loss or risk aversion.     

Superstition and “lucky” apartments: Evidence from transaction-level data

Using a sample of apartment transactions during 2004–2006 in Chengdu, China, we investigate the impact of superstitions in the Chinese real estate market. Numerology forms an important component of Chinese superstitious lore, with the numbers 8 and 6 signifying good luck, and the number 4 bad luck. We find that secondhand apartments located on floors ending with “8” fetch, on average, a 235 RMB higher price (per square meter) than on other floors. For newly constructed apartments, this price premium disappears due to uniform pricing of new housing units, but apartments on floors ending in an “8” are sold, on average, 6.9 days faster than on other floors. Buyers who have a phone number containing more “8”’s are more likely to purchase apartments in a floor ending with “8”; this suggests that at least part of the price premium for “lucky” apartments arises from the buyers’ superstitious beliefs.     

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).     

Endogenous uncertainty in a general equilibrium model with price contingent contracts

Summary This paper views uncertainty and economic fluctuations as being primarily endogenous and internally propagated phenomena. The most important Endogenous Uncertainty examined in this paper is price uncertainty which arises when agents do not have structural knowledge and are complelled to make decisions on the basis of their beliefs. We assume that agents adopt Rational Beliefs as in Kurz [1994a]. The trading of endogenous uncertainty is accomplished by using Price Contingent Contracts (PCC) rather than the Arrow-Debreu state contingent contracts. The paper provides a full construction of the price state space which requires the expansion of the exogenous state space to include the state of beliefs. This construction is central to the analysis of equilibrium with endogenous uncertainty and the paper provides an existence theorem for a Rational Belief Equilibrium with PCC. It shows how the PCC completes the markets for trading endogenous uncertainty and lead to an allocation which is Pareto optimal. This paper also demonstrates that endogenous uncertainty is generically present in this new equilibrium.This research was supported in part by the Fondazione Eni Enrico Mattei of Milan, Italy, and by the National Science Council of Taiwan. The authors thank Carsten K. Nielsen for valuable suggestions.     

Are high–frequency traders informed?

Are high–frequency traders (HFTs) informed? To address this question, we examine HFTs' activity in the call auction environment, where speed-related trading is limited and signal processing capacity becomes more relevant. To model the call market, we consider the Kyle (1989) rational expectations framework for strategic trading. The test we propose for detecting informed HFTs in this market assesses potential deviations of the informativeness of HFTs' aggregate (net) demand, from the informativeness of the aggregate demand submitted by the rest of the traders. Data from the Euronext Paris preopening phase indicate that informed HFTs are present in the market just before the opening. Our results provide useful guidance for the assessment of the influence of HFTs’ quotes on price quality, an important issue for market regulators and policy makers.     

How does the diversity of investors’ beliefs affect stock price informativeness?

A growing number of studies have investigated the role of stock prices in aggregating private information and guiding resource reallocation. However, this article may be the first attempt to study how the diversity of beliefs affects stock price informativeness. The framework of the noisy rational expectations model shows that stock informativeness is determined by both the precision and use of private information in trading. If private beliefs about the value are highly diverse, the aggregate average opinion revealed in a stock’s price will be more accurate and, thus, more informative. As the price becomes more informative, however, individual investors will rely less on their private information. When this occurs, less private information will be absorbed in price, which, in turn, reduces price informativeness. Our model shows that the relationship between belief diversity and price informativeness is U-shaped in equilibrium.     

Risk taking by agents: The role of ex-ante and ex-post accountability

We study the role of accountability in situations where an agent makes risky decisions for a principal. We observe that in the absence of accountability, agents choose less risk averse investments for the principal than investors who invest for their own account. Accountability mitigates the observed decrease in risk aversion. Differences are observed between situations where agents are accountable for their decision (“ex-ante”) and where they are accountable for the outcome (“ex-post”).     

Risk aversion and allocation to long-term bonds

As risk aversion approaches infinity, the portfolio of an investor with utility over consumption at time T is shown to converge to the portfolio consisting entirely of a bond maturing at time T. Previous work on bond allocation requires a specific model for equities, the term structure, and the investor's utility function. In contrast, the only substantive assumption required for the analysis in this paper is that markets are complete. The result, which holds regardless of the underlying investment opportunities and the utility function, formalizes the “preferred habitat” intuition of Modigliani and Sutch (Amer. Econom. Rev. 56 (1966) 178).     

Momentum in global equity markets in times of troubles: Does the economic state matter?

This paper investigates the profitability of momentum-based trading strategies pursued during the most recent economic downturns in global equity markets. In contrast to previous studies, it reveals that such strategies generated statistically significant negative returns during the most recent recessions. These “momentum crashes” happen during market reversals following exceptionally large market declines, as occurred in March and April 2009.     

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.     

Rational expectations,difference of opinions and asset pricing

This article applies the concept of relative overconfidence (the measure of how heavily investors depend on others’ information) to combine the rational expectations equilibrium (REE) and difference of opinions (DO) models. And we discuss the effects of relative overconfidence on asset price efficiency and trading volume. We find that when investors hold assets to maturity, relative overconfidence has no effect on price efficiency and trading volume; however, when investors speculate, relative overconfidence reduces price informativeness and trading volume, because investors will reckon asset prices as more noisy and find it meaningless to speculate on capital gains based on their private information. Our results highlight the role of speculation in differentiating REE and DO models and influencing the effects of overconfidence.     

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.     

Asymmetric English auctions

This paper studies equilibria of the n-bidder single-object English, or open ascending price, auction in a setting with interdependent values and asymmetric bidders. Maskin (in: H. Siebert (Ed.), Privatization, Institut fur Weltwirtschaften der Universität Kiel, Kiel, 1992, pp. 115-136.) showed that if the values satisfy a “single crossing” condition, then the two-bidder English auction has an efficient equilibrium. In this paper, two extensions of the single crossing condition, the “average crossing” condition and the “cyclical crossing” condition, are introduced. The main result is that under either of these conditions the n-bidder English auction has an efficient equilibrium.     

Firms’ location decision across asymmetric countries and employment inequality

This paper analyzes the effect of globalization (lower trade costs) on production and trade patterns if, firms are vertically linked, stages of production differ in labor-factors intensity and countries differ in labor-factors prices. In order to reflect the “Continental Europe” experience, relative wages are assumed fixed and spatial changes in production are translated into changes in relative (skilled to unskilled) employment levels. The asymmetry in factors prices across countries results in a unique agglomeration equilibrium for a broad range of trade costs. At low trade costs, firms’ location depends on production costs—vertical specialization occurs. This paper also provides a consistent explanation of the observed increase in employment inequality between skilled and unskilled workers in relatively high-unskilled wage countries.     

Capital account liberalization and dynamic price discovery: evidence from Chinese cross-listed stocks

We analyse the effects of a recent financial reform (Shanghai-Hong Kong Stock Connect) that enables cross-market investment between Hong Kong and Shanghai stock exchanges. Using a VECM, we find that the reform announcement considerably narrows the equilibrium level of price disparity and strengthens the price comovement of shares that are cross-listed in both markets. The estimated equilibrium relationship is in support of the relative law of one price. We find that both markets adjust in response to a disequilibrium in price disparity, leading to a sizeable error correction activity. The Shanghai market contributes to approximately two-thirds of the price discovery process. Competition and informativeness of trading affect the relative role of price discovery in each market. Finally, the reform implementation reinforces the long-run cointegration relationship and strengthens the short-run price comovements of cross-listed stocks despite the widening price disparity during the period.