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Dynamic Trading and Asset Prices: Keynes vs. Hayek

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  • Cespa, Giovanni
  • Vives, Xavier

Abstract

We investigate the dynamics of prices, information and expectations in a competitive, noisy, dynamic asset pricing equilibrium model. We show that prices are farther away from (closer to) fundamentals compared with average expectations if and only if traders over- (under-) rely on public information with respect to optimal statistical weights. Both phenomena, in turn, occur whenever traders speculate on short-run price movements. For a given, positive level of residual payoff uncertainty, over-reliance on public information obtains if noise trade displays low persistence. This defines a "Keynesian" region; the complementary region is "Hayekian" in that prices are systematically closer to fundamentals than average expectations. The standard case of no residual uncertainty and noise trading following a random walk is on the frontier of the two regions and identifies the set of deep parameters for which traders abide by Keynes' dictum of concentrating on an asset "long term prospects and those only." The analysis explains accommodation and trend chasing strategies as well as momentum and reversal.

Suggested Citation

  • Cespa, Giovanni & Vives, Xavier, 2009. "Dynamic Trading and Asset Prices: Keynes vs. Hayek," CEPR Discussion Papers 7506, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:7506
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    References listed on IDEAS

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    Cited by:

    1. Giovanni Cespa & Xavier Vives, 2016. "High Frequency Trading and Fragility," CESifo Working Paper Series 6279, CESifo Group Munich.
    2. Han, Yufeng & Zhou, Guofu & Zhu, Yingzi, 2016. "A trend factor: Any economic gains from using information over investment horizons?," Journal of Financial Economics, Elsevier, vol. 122(2), pages 352-375.
    3. Peck, James, 2014. "A battle of informed traders and the market game foundations for rational expectations equilibrium," Games and Economic Behavior, Elsevier, vol. 88(C), pages 153-173.
    4. Cespa, Giovanni & Vives, Xavier, 2011. "Expectations, Liquidity, and Short-term Trading," CEPR Discussion Papers 8303, C.E.P.R. Discussion Papers.
    5. Marco Ottaviani & Peter Norman Sørensen, 2015. "Price Reaction to Information with Heterogeneous Beliefs and Wealth Effects: Underreaction, Momentum, and Reversal," American Economic Review, American Economic Association, vol. 105(1), pages 1-34, January.
    6. Albuquerque, Rui & Miao, Jianjun, 2014. "Advance information and asset prices," Journal of Economic Theory, Elsevier, vol. 149(C), pages 236-275.
    7. 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.
    8. Giovanni Cespa & Xavier Vives, 2015. "The Beauty Contest and Short-Term Trading," Journal of Finance, American Finance Association, vol. 70(5), pages 2099-2154, October.
    9. Liu, Hong & Wang, Yajun, 2016. "Market making with asymmetric information and inventory risk," Journal of Economic Theory, Elsevier, vol. 163(C), pages 73-109.
    10. George-Marios Angeletos & Guido Lorenzoni & Alessandro Pavan, 2010. "Beauty Contests and "Irrational Exuberance": A Neoclassical Approach," Discussion Papers 1502, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    11. Andrei, Daniel & Cujean, Julien, 2017. "Information percolation, momentum and reversal," Journal of Financial Economics, Elsevier, vol. 123(3), pages 617-645.
    12. 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.
    13. repec:eee:macchp:v2-1065 is not listed on IDEAS
    14. Albagli, Elias, 2015. "Investment horizons and asset prices under asymmetric information," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 787-837.
    15. Cespa, Giovanni & Vives, Xavier, 2011. "Higher order expectations, illiquidity, and short-term trading," IESE Research Papers D/915, IESE Business School.
    16. Jia, Xue, 2016. "On the role of information disclosures in capital markets," Other publications TiSEM 9bacfbaa-2162-49fe-92e6-5, Tilburg University, School of Economics and Management.
    17. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.
    18. Pavan, Alessandro & Vives, Xavier, 2015. "Information, Coordination, and Market Frictions: An Introduction," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 407-426.
    19. Nimark, Kristoffer P, 2017. "Dynamic Higher Order Expectations," CEPR Discussion Papers 11863, C.E.P.R. Discussion Papers.
    20. Kristoffer Nimark, 2017. "Dynamic Higher Order Expectations," 2017 Meeting Papers 1132, Society for Economic Dynamics.

    More about this item

    Keywords

    Average expectations; Efficient market hypothesis; Higher order beliefs; Long and short-term trading; Momentum; Opaqueness; Over-reliance on public information; Reversal;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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