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Profitable informed trading in a simple general equilibrium model of asset pricing

James Dow

Profitable informed trading in a simple general equilibrium model of asset pricing

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  • 20 Currently reading

Published by National Bureau of Economic Research in Cambridge, Mass .
Written in English

    Subjects:
  • Speculation -- Mathematical models.,
  • Information theory in economics.,
  • Stocks -- Prices -- Mathematicalmodels.

  • Edition Notes

    StatementJames Dow, Gary Gorton.
    SeriesNBER working paper series -- no.4315
    ContributionsGorton, Gary., National Bureau of Economic Research.
    The Physical Object
    Pagination57,[1]p. ;
    Number of Pages57
    ID Numbers
    Open LibraryOL19593042M

    Equilibrium requires that the less informed’s rate of return equal the informed’s. The less informed control a stable equilibrium percentage of total wealth. Because an individual’s recent investment experience correlates with his ter minal wealth, learning need not reduce the less informed’s risky asset . In the simple world of the CAPM, the market portfolio, M, is the optimal tangency portfolio on the efficient frontier. -The abnormal rate of return on a security in excess of what would be predicted by an equilibrium model like CAPM. Chapter 9: Capital Asset Pricing Model. 42 terms. Fin Exam 2. 88 terms. FIN Ch. 6 & 7. 42 terms.


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Profitable informed trading in a simple general equilibrium model of asset pricing by James Dow Download PDF EPUB FB2

We present a simple general equilibrium model of asset pricing in which profitable informed trading can occur without any "noise" added to the model.

We use an equilibrium concept similar to rational expectations equilibrium, but which explicitly allows Cited by:   This paper presents a simple general equilibrium model of asset pricing in which profitable informed trading can occur without any "noise" added to the model.

It shows that models of profitable informed trading must restrict the portfolio choices of uninformed traders: in particular, they cannot buy the market by: 2. Downloadable (with restrictions). This paper presents a simple general equilibrium model of asset pricing in which profitable informed trading can occur without any "noise" added to the model.

It shows that models of profitable informed trading must restrict the portfolio choices of uninformed traders: in particular, they cannot buy the market portfolio. Profitable informed trading in a simple general equilibrium model of asset pricing.

Journal. Journal of Economic Theory. Subject. Finance. Publishing details. Journal of Economic Theory November Vol p Authors / Editors.

Dow J; Gorton G. Biographies. Profitable Informed Trading in a Simple General Equilibrium Model of Asset Pricing. NBER Working Paper No. w Number of pages: 61 Posted: 10 Jul James Dow and Gary B. Gorton. London Business School - Institute of Finance and Accounting and Yale School of Management.

Download PDF: Sorry, we are unable to provide the full text but you may find it at the following location(s): (external link). Profitable Informed Trading in a Simple General Equilibrium Profitable informed trading in a simple general equilibrium model of asset pricing book of Asset Pricing Journal of Economic Theory,67, (2), View citations (16) See also Working Paper () Arbitrage Chains Journal of Finance,49, (3), View citations (69) See also Working Paper () Bank Regulation When 'Banks' and 'Banking' Are.

Equilibrium Asset Pricing. In equilibrium, asset prices clear the markets i.e., - bond holdings of all agents = 0, - total stock = aggregate number of shares. Identical agents in terms of preferences and endowments: a representative agent model. Steps: i. Given preferences, technology and endowments, solve for equilibrium intertemporal.

In the context of our underlying information‐cost story, it is, thus, ambiguous how the equilibrium distribution of q k would be affected between the diagonal and more‐general version of the model.

26 26 Much the same discussion would apply to extending the model to include multiple factors in the context of the Arbitrage Pricing Model. 24 Miao () proves that in a general framework, of which the Krusell and Smith () economy is a special case, the competitive equilibrium can be characterized using the computed equilibrium from the approximate aggregation algorithm, provided that the competitive equilibrium is unique.

My model satisfies this uniqueness condition by. Dow, J. and Gorton, G. () Profitable informed trading in a simple general equilibrium model of asset pricing.

Journal of Economic Theory, – zbMATH CrossRef Google Scholar Equilibrium Asset Pricing and Portfolio Choice of month t rely on price and return data prior to monthwe only use 66 information available to market participants when they chose their portfolios. 67 Hence, our result that the optimal price-contingent allocation strategy outperforms the index differs from the findings of Fama and French ().

The simplest such model features two agents with different beliefs, trading over time in a market for two securities, a risk-free security and a risky security, which can be viewed as the market portfolio. The formal analysis focuses on underlying state prices. The equilibrium pricing equation involves the state price vector ν.

General equilibrium theory both studies economies using the model of equilibrium pricing and seeks to determine in which circumstances the assumptions of general equilibrium will hold.

The theory dates to the s, particularly the work of French economist Léon Walras in his pioneering work Elements of Pure Economics. CAPM (Capital Asset Pricing Model) an equilibrium model of the relationship between risk and return that characterizes a security's expected return based on its beta with the market portfolio.

the ratio of the book value of equity to the market value of equity. momentum strategy. 4The classic examples of this approach are the Walrasian general equilibrium model discussed in L eon Walras’ \Elements Of Pure Economics" (), and Gerard Debreu’s \Theory of Value" ().

5 The di erence between the stock return and the risk-free interest rate. Profitable Informed Trading in a Simple General Equilibrium Model of Asset Pricing NBER Working Papers, National Bureau of Economic Research, Inc View citations (1) See also Journal Article in Journal of Economic Theory () Nash equilibrium under knightian uncertainty: breaking-down backward induction.

the single asset.] The contribution of an individual asset to the portfolio’s standard deviation: Beta • Beta measures the sensitivity of an assetBeta measures the sensitivity of an asset s’s rate of return to variation in the market portfolio’s return.

• Beta for asset i can be. the definition of a riskless asset depends on preferences and endowments, and so cannot be specified a priori.

Introduction This paper is devoted to clarifying the relationship between the CAPM stock market trading model and general equilibrium with incomplete markets. CAPM yields three impor-tant views of financial markets. Asset Pricing Model has been tested. The Capital Asset Pricing Model (or CAPM) is an equilibrium model which relates asset’s risk measured by beta to its returns.

It states that in a competitive market the expected rate of return on an asset varies in direct proportion to its beta. () “ Reputation Formation in Early Bank Note Markets,” Journal of Political Economy, Vol. No. 2, () “ Profitable Informed Trading in a Simple General Equilibrium Model of Asset Pricing,” with James Dow, Journal of Economic Theory, Vol.

67, No. 2: II. Capital Market Equilibrium With Incomplete Information In this section, we develop a two-period model of capital market equilibrium in an environment where each investor knows only about a subset of the available securities. In subsequent sections, we explore the impact on the structure of equilibrium asset prices caused by this particular.

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

equilibrium.4 In the model of this paper, instead, the long-run distribution of wealth across agents is non-degenerate and margin requirements are occasionally binding in a stationary equilibrium. A less directly related literature is the one on asset pricing with incomplete markets (see Heaton and Lucas () and their references).

Notes on Macroeconomic Theory. This note explains the following topics: Simple Representative Agent Models, Growth With Overlapping Generations, Neoclassical Growth and Dynamic Programming, Endogenous Growth, Choice Under Uncertainty, Consumption and Asset Pricing, Search, Money and Unemployment, Overlapping Generations Models of Money, A Cash-In-Advance Model.

Abstract: In this paper we present a general equilibrium model to analyze competition between multiple venues (dealers), endogenous market segmentation, transaction speeds and fees, trading volume, optimal regulator’s choice for taxing traders, and welfare in illiquid asset markets.

Differences in trading speed between different venues lead. tal Theorem of Asset Pricing may not hold in infinite-dimensional economies is discussed in [1, 8, 14, 24, 26, 33], and many others. 3 Wealth constraints are often used in continuous-trade models [4, 5, 11, 19, 26] and in dis-crete-time, infinite-horizon general equilibrium models [17.

Equilibrium Asset Pricing Under Heterogeneous Information Abstract We analyze theoretically and empirically the implications of heterogeneous information for equi-librium asset pricing and portfolio choice.

Our theoretical framework, directly inspired by Admati (), implies that with partial information aggregation, portfolio separation fails.

Financial Markets Theory presents classical asset pricing theory, a theory composed of milestones such as portfolio selection, risk aversion, fundamental asset pricing theorem, portfolio frontier, CAPM, CCAPM, APT, the Modigliani-Miller Theorem, no arbitrage/risk neutral evaluation and information in financial markets.

Starting from an analysis of the empirical tests of the above theories, 5/5(1). Coming back to the topic of discussion, Market makers also help reduce price volatility which leads to fair pricing of the assets. For instance, any given asset has the difference between the best bid and best ask, which is known as the bid-ask spread.

Here it is important to note that low liquidity in the markets leads to the wide bid-ask spread. cost curvature a ects the equilibrium dynamics of stock returns and investment rates, which exempli es the endogenous link between asset prices and macroeconomic quantities in general equilibrium models.

Equations (8) and (9) can be used as partial-equilibrium restrictions to relate stock prices to productivity shocks and the SDF.

Keywords: Capital Asset Pricing Model, Arbitrage Pricing The-ory, asset pricing. 1 Introduction Based on the pioneering work of Markowitz () and Tobin () for risky assets in a portfolio, Sharpe (), Lintner () and Mossin () derived a general equilibrium model for the pricing of assets under uncertainty, called the Capital.

1 lie standard form of the general equilibrium relationship for asset returns was developed independently by Sharpe, Lintner, and Mossin.

Hence, it is often referred to as the ihai pe-Lintner-Mossin form of the capital asset pricing model. Search frictions in the labor market help explain the equity premium in the financial market.

We embed the Diamond-Mortensen-Pissarides search framework into a dynamic stochastic general equilibrium model with recursive preferences.

The model produces a sizeable equity premium of % per annum with a low interest rate volatility of %. Considerable attention has recently been given to general equilibrium models of the pricing of capital assets.

Of these, perhaps the best known is the mean-variance formulation originally developed by Sharpe () and Treynor (), and extended and clarified by Lintner (a; b), Mossin (), Fama (a; b), and Long ().

In addition Treynor (), Sharpe (), and Jensen. 2 The Model In this section we describe a general equilibrium with heterogeneous rms that are nanced with both debt and equity.

The model is designed to merge many key features of the investment and nancing behavior of rms in a modern asset pricing setting. Firms produce a unique nal good that can be used for both consumption an investment. They. The profit of the informed trader in a given market, which is equal to the losses sustained by the liquidity and noise traders in that market, is positively related to the information advantage of the informed trader.

4 If there were no noise traders in any asset, then liquidity traders would minimize their trading losses to the informed by. Ross () provides a simple and elegant upper bound on the predictive regression R-squared that R 2 = (1 + R_f) 2 Var(m) for a given asset pricing model with kernel m, where R_f is the riskfree rate of return.

In this paper, we tighten this bound by a squared factor of the correlation between the default pricing kernel and the state variables. effect of agency costs on equilibrium asset prices. Obviously, our model also relates to the heterogeneous-agent equilibrium asset pricing literature.

5 The papers more closely related to ours are Dow et al. () and Gorton and He (). Dow et al. () develop a model in which the manager has an empire build. The spread is profitable if the underlying asset increases in price, but the upside is limited due to the short call strike.

The benefit, however, is that selling the higher strike call reduces. The remainder of the paper is organized as follows: in Section 2, we propose the equilibrium asset pricing model. We then solve the equilibrium asset prices in Section 3 in the special case in which EIS and RRAD are one and investigate the properties of the equilibrium.

In Section 4, we numerically solve the equilibrium in the general case.THE CAPITAL ASSET PRICING MODEL The capital asset pricing model is a set of predictions concerning equilibrium expected returns on risky assets.

Harry Markowitz laid down the foundation of modern portfolio management in The CAPM was developed 12 years later in articles by William Sharpe, John Lintner, and Jan Mossin.Milgrom () type equilibrium model to investigate the decision of informed traders on whether to use limit or market orders.

Specifically, the market for an asset consists of risk-neutral agents: informed traders, uninformed traders, and a market maker. Before the initial trading the informed traders learn the true asset.