(with Kevin Crotty), Economics Letters, Forthcoming
Abstract: We jointly quantify the magnitude of risk aversion and transactions costs implied by asset pricing models with trading frictions. With constant relative risk aversion and symmetric transactions costs, estimated transactions costs on Treasury bills are implausibly high, a manifestation of the risk-free rate puzzle. Introducing short-selling costs for Treasury bills offers a resolution of the puzzle. The resulting confidence sets show upper bounds on risk-aversion to be at reasonable levels. Short-selling costs for Treasuries are not necessary under recursive preferences.
Abstract: I present a model of belief formation in asset markets based on the law of small numbers heuristic (Tversky and Kahneman, 1971) and study its implications for both asset prices and portfolio choices. This heuristic is the belief that small samples should be representative of the population, which leads to hysteresis in beliefs. The following properties arise in a in a continuous time Lucas Orchard in which a subset of investors believes in the law of small numbers: (1) asymmetric v-shaped trading patterns; (2) the disposition effect; (3) momentum; (4) reversal. Momentum crashes occur, and the reversal of momentum returns is slower when portfolios are formed with larger assets. Belief in the law of small numbers implies predictable patterns in beliefs. I show that the risk associated with the momentum strategy can be managed by accounting for this predictability.
(with Kerry Back and Ruomeng Liu)
Abstract: Dealers who acquire inventory in one transaction usually seek to dispose of it in a second transaction. If the terms of the first transaction are disclosed, then dealers will engage in costly signaling, offering unduly favorable prices in the first transaction to signal asset quality to the second counterparty. Costly signaling lowers spreads and increases volume, market liquidity, and investor welfare. Aggregate welfare is higher in transparent markets, but dealers prefer opacity when potential gains from trade are large and/or adverse selection is low.
(with Semyon Malamud)
Abstract:
We derive closed form expressions for equilibrium asset prices and liquidity in an economy populated by a finite number of large, strategic, risk averse investors. The model allows for arbitrary risk preferences, any number of assets, and an arbitrary distribution of asset payoffs. In equilibrium, assets are priced according to the standard consumption Euler equation plus a correction term accounting for market illiquidity (price impact), linked to an endogenous measure of systemic risk that puts a large weight on low consumption states. Wealth effects imply that price impact is generally asymmetric, which leads to the emergence of endogenous systemic assets: That is, assets whose sell-off triggers large moves in all security prices. Market liquidity is non-monotonic in funding liquidity and may decrease in the number of investors. In the presence of liquidity shortage, price impact becomes negative and gives rise to an illiquidity premium in asset prices.
(with Florent Gallien, Serge Kassibrakis, Semyon Malamud, and Nataliya Klimenko)
Abstract: Foreign exchange operates as a two-tiered over-the-counter (OTC) market dominated by a handful of large, strategic dealers. Using proprietary high frequency data on quotes by the major dealers in the Dealer-to-client market, we find a significant heterogeneity in their behavior. We develop a model of strategic competition that accounts for this heterogeneity and the two-tier market structure. We use the model to recover dealers’ risk aversions and inventories from their quotes and construct an endogenous measure of systemic, non-diversifiable risk, capturing the cross-sectional liquidity-risk mismatch. Consistent with the model predictions, we find that liquidity mismatch negatively predicts LP quotes, both in the time series and in the cross-section.
Abstract: The presence of information asymmetry increases the probability that a potential predator will provide liquidity rather than engaging in predatory trading during liquidation by a distressed trader. More information asymmetry is associated with lower expected losses from liquidation for the distressed trader in illiquid markets. There is a negative correlation between the degree of information asymmetry and the returns from predatory trading, which is consistent with empirical findings. These results imply that strategic traders are more likely to stabilize markets by providing liquidity when information is asymmetric. These findings highlight a cost associated with disclosure and can explain the documented rarity of illiquidity episodes in financial markets.
(with Kerry Back and Ruomeng Liu)
Abstract: We derive the optimal portfolio for an investor with increasing relative risk aversion in a complete continuous-time securities market. The IRRA assumption helps to mitigate the criticism of constant relative risk aversion that it implies an unreasonably large aversion to large gambles, given reasonable aversion to small gambles. The model provides theoretical support for the common recommendation of financial advisors that older investors should reduce their allocations to risky assets and is consistent with empirical findings on the relations between age, wealth, and portfolios. Preferences for habits and IRRA preferences have some similar implications and are complementary assumptions.
Abstract: Blizzards in Manhattan, New York, NY cause a significant reduction in trading volume for firms located outside of the Northeast region of the United States of America. I use this exogenous change in volume to establish the causal relationship between volume and volatility. I find that the drop in volume cause a drop firms’ observed volatility. The effect is stronger post 2003 and NYSE’s implementation of “autoquote”, which led to an increase in trading volume from Algorithmic traders. Our evidence suggests that trading activity by institutional investors (in of itself) increases volatility.
(with Kerry Back and Ruomeng Liu)
Abstract: Dealers who acquire inventory in one transaction usually seek to dispose of it in a second transaction. If the terms of the first transaction are disclosed, then dealers will engage in costly signaling, offering unduly favorable prices in the first transaction to signal asset quality to the second counterparty. Costly signaling lowers spreads and increases volume, market liquidity, and investor welfare. Aggregate welfare is higher in transparent markets, but dealers prefer opacity when potential gains from trade are large and/or adverse selection is low.