Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding

Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding

Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding

Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding

Synopsis

Asset prices are driven by public news and information that is often dispersed among many market participants. These agents try to infer each other's information by analyzing price processes. In the past two decades, theoretical research in financial economics has significantly advanced ourunderstanding of the informational aspects of price processes. This book provides a detailed and up-to-date survey of this important body of literature. The book begins by demonstrating how to model asymmetric information and higher-order knowledge. It then contrasts competitive and strategic equilibrium concepts under asymmetric information. It also illustrates the dependence of information efficiency and allocative efficiency on the securitystructure and the linkage between both efficiency concepts. No-Trade theorems and market breakdowns due to asymmetric information are then explained, and the existence of bubbles under symmetric and asymmetric information is investigated. The remainder of the survey is devoted to contrasting different market microstructure models that demonstrate how asymmetric information affects asset prices and traders' information , which provide a theoretical explanation for technical analysis and illustrate why some investors "chase the trend."The reader is then introduced to herding models and informational cascades, which can arise in a setting where agents' decision-making is sequential. The insights derived from herding models are used to provide rational explanations for stock market crashes. Models in which all traders are inducedto search for the same piece of information are then presented to provide a deeper insight into Keynes' comparison of the stock market with a beauty contest. The book concludes with a brief summary of bank runs and their connection to financial crises.

Excerpt

A vast number of assets changes hands every day. Whether these assets are stocks, bonds, currencies, derivatives, real estate, or just somebody's house around the corner, there are common features driving the market price of these assets. For example, asset prices fluctuate more wildly than the prices of ordinary consumption goods. We observe emerging and bursting bubbles, bullish markets, and stock market crashes.

Another distinguishing feature of assets is that they entail uncertain payments, most of which occur far in the future. the price of assets is driven by expectations about these future payoffs. New information causes market participants to re-evaluate their expectations. For example, news about a company's future earning prospects changes the investors' expected value of stocks or bonds, while news of a country's economic prospects affects currency exchange rates. Depending on their information, market participants buy or sell the asset. in short, their information affects their trading activity and, thus, the asset price. Information flow is, however, not just a one-way street. Traders who do not receive a piece of new information are still conscious of the fact that the actions of other traders are driven by their information set. Therefore, uninformed traders can infer part of the other traders' information from the current movement of an asset's price. They might be able to learn even more by taking the whole price history into account. This leads us to the question of the extent to which technical or chart analysis is helpful in predicting the future price path.

There are many additional questions that fascinate both professionals and laymen. Why do bubbles develop and crashes occur? Why is the trading volume in terms of assets so much higher than real economic activity? Can people's herding behavior be simply attributed to irrational panic? Going beyond positive theory, some normative policy issues also arise. What are the early warning signals indicating that a different policy should be adopted? Can a different design of exchanges and other financial institutions reduce the risk of crashes and bubbles?

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