Research in Financial Economics

Princeton University, Princeton NJ

Investigators

Abstract

The proposal involves two research projects. In the first project, the PI investigates the consequences of speculative trading in financial markets. The PI is especially interested in cases where speculative trading is produced by overconfident investors who think that their knowledge about assets is more precise than it really is. Overconfidence creates disagreement among investors. An asset owner has an option to sell the asset to other agents who have more optimistic beliefs. This resale option is valuable if short sales are costly. The resale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. The model explains why, when transaction costs are low, price bubbles are accompanied by significant increases in trading volume and high price volatility as it has been observed in many actual episodes of asset bubbles. Some predictions of the model will be tested using data on stocks prices in China and on US closed-end funds. The PI will also consider markets with a finite number of risk-averse investors to investigate the impact of changes in asset supply on the speculative component of asset prices. Speculative trading also has consequences for the design of executive compensation and the behavior of managers. The PI proposes to investigate the role of speculative trading in generating the compensation packages that seem to have led many corporate managers to pursue strategies that maximize short-term stock performance at the expense of the long run fundamentals. The second research project aims at exploiting the Markov structure that is present in several of the asset pricing models that are used in practice, to increase our understanding of how the behavior of asset returns in the short-run are transmitted into the prices of securities with payoffs in the long run. This will allow us to perform new tests on theoretical models of asset pricing.