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Dynamic Trading and Asset Prices: Keynes vs. Hayek

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  • Giovanni Cespa

    ()
    (Queen Mary University of London, Università di Salerno, CSEF and CEPR)

  • Xavier Vives

    (IESE Business School and UPF)

Abstract

We investigate the dynamics of prices, information and expectations in a competitive, noisy, dynamic asset pricing equilibrium model. We look at the bias of prices as estimators of fundamental value in relation to traders' average expectations and note that prices are more (less) biased than average expectations if and only if traders over- (under-) rely on public information with respect to optimal statistical weights. We find that prices are biased in relation to average expectations whenever traders speculate on short-run price move- ments. In a market with long term traders, over-reliance on public information obtains if noise trade increments are correlated enough and/or there is low enough residual uncertainty in the payoff. This defines a “Keynesian” region; the complementary region is “Hayekian” in that prices are less biased than average expectations in the estimation of fundamental value. The standard case of no residual uncertainty and noise trading following a random walk is on the frontier of the two regions. With short-term traders there typically are two equilibria, with the stable (unstable) one displaying over- (under-) reliance on public information.

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Bibliographic Info

Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 191.

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Date of creation: 01 Jan 2008
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Publication status: Published in Review of Economic Studies (2012) 79 (2): 539-580.
Handle: RePEc:sef:csefwp:191

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Keywords: Price bias; long and short-term trading; multiple equilibria; average expectations; higher order beliefs; over-reliance on public information.;

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References

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  1. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
  2. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
  3. Vives, Xavier, 1995. "Short-Term Investment and the Informational Efficiency of the Market," Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 125-60.
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  6. Luis Angel Medrano & Xavier Vives, 2004. "Regulating Insider Trading When Investment Matters," Review of Finance, Springer, vol. 8(2), pages 199-277.
  7. Carolina Manzano & Xavier Vives, 2010. "Public and Private Learning from Prices, Strategic Substitutability and Complementarity, and Equilibrium Multiplicity," CESifo Working Paper Series 3137, CESifo Group Munich.
  8. Philippe Bacchetta & Eric van Wincoop, 2004. "Higher Order Expectations in Asset Pricing," Working Papers 04.03, Swiss National Bank, Study Center Gerzensee.
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  14. Cespa, Giovanni & Foucault, Thierry, 2008. "Insiders-Outsiders, Transparency and the Value of the Ticker," CEPR Discussion Papers 6794, C.E.P.R. Discussion Papers.
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Citations

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Cited by:
  1. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2007. "Wall Street and Silicon Valley: A Delicate Interaction," NBER Working Papers 13475, National Bureau of Economic Research, Inc.
  2. Albuquerque, Rui & Miao, Jianjun, 2007. "Advance Information and Asset Prices," CEPR Discussion Papers 6588, C.E.P.R. Discussion Papers.
  3. Kristoffer Nimark, 2009. "Speculative dynamics in the term structure of interest rates," Economics Working Papers 1194, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 2012.
  4. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.

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