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Dynamic Trading and Asset Prices: Keynes vs. Hayek

  • Giovanni Cespa


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

  • Xavier Vives

    (IESE Business School and UPF)

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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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
Date of revision:
Publication status: Published in Review of Economic Studies (2012) 79 (2): 539-580.
Handle: RePEc:sef:csefwp:191
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  12. Marco Ottaviani & Peter Norman Sørensen, 2009. "Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets," Discussion Papers 09-14, University of Copenhagen. Department of Economics.
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  16. Cespa, Giovanni & Vives, Xavier, 2011. "Higher order expectations, illiquidity, and short-term trading," IESE Research Papers D/915, IESE Business School.
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  25. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
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