Shorting in Speculative Markets

We propose a continuous-time model of trading with heterogeneous beliefs. Risk-neutral agents face quadratic costs-of-carry on positions and thus their marginal valuations decrease with the size of their position, as it would be the case for risk-averse agents. In the equilibrium models of heterogeneous beliefs that followed Harrison-Kreps, investors are risk-neutral, short-selling is prohibited and agents face constant marginal costs of carrying positions. The resulting resale option guarantees that the price exceeds the price of the asset when speculation is ruled out; the difference is identified as a bubble. In our model increasing marginal costs entail that the price depends on asset supply. Second, agents also value an option to delay, and this may cause the market to equilibrate below the buy-and-hold price. Third, we introduce the possibility of short-selling. A Hamilton-Jacobi-Bellman equation of a novel form quantifies precisely the influence of the costs-of-carry on the price. An unexpected decrease in shorting costs may lead to the collapse of a bubble; this links the financial innovations that facilitated shorting of MBSs to the subsequent collapse of prices.