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Trading on Sunspots

Author

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  • Boyan Jovanovic
  • Viktor Tsyrennikov

Abstract

In a model with multiple Pareto-ranked equilibria we add trade in assets that pay based on the realization of a sunspot. Asset trading restricts the equilibrium set in a way that raises welfare by eliminating equilibria with a high likelihood of disasters. When the probability of a disaster is high enough, the coordination game becomes like a prisoner’s dilemma situation in which the high-output equilibrium disappears because the portfolios that agents choose induce them to produce less. We derive an upper bound on the disaster probability, we derive asset pricing implications including the disaster premium, and we study the effect on stock prices of news shocks to beliefs.

Suggested Citation

  • Boyan Jovanovic & Viktor Tsyrennikov, 2014. "Trading on Sunspots," NBER Working Papers 20813, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:20813
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • G1 - Financial Economics - - General Financial Markets

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