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Dynamic trading and asset prices: Keynes vs. Hayek

  • Cespa, Giovanni

    (Queen Mary University of London)

  • Vives, Xavier

    ()

    (IESE Business School)

We investigate the dynamic 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 movements. In a market with long traders, over-reliance on public information obtains if noise trader 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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File URL: http://www.iese.edu/research/pdfs/DI-0716-E.pdf
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Paper provided by IESE Business School in its series IESE Research Papers with number D/716.

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Length: 51 pages
Date of creation: 09 Nov 2007
Date of revision:
Handle: RePEc:ebg:iesewp:d-0716
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IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN

Web page: http://www.iese.edu/

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  11. Xavier Vives & Giovanni Cespa, 2011. "Higher Order Expectations, Illiquidity, and Short Term Trading," 2011 Meeting Papers 929, Society for Economic Dynamics.
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  13. Manzano, Carolina & Vives, Xavier, 2010. "Public and Private Learning from Prices, Strategic Substitutability and Complementarity, and Equilibrium Multiplicity," CEPR Discussion Papers 7949, C.E.P.R. Discussion Papers.
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