We analyze a tractable rational expectations equilibrium model with margin constraints. We argue that constraints affect and are affected by informational efficiency, leading to a novel amplification mechanism. A decline in wealth tightens constraints and reduces investors’ incentive to acquire information, lowering price informativeness. Lower informativeness, in turn, increases the risk borne by financiers who fund trades, leading them to further tighten constraints faced by investors. This information spiral leads to (i) significant increases in risk premium and return volatility in crises, when investors’ wealth declines, (ii) complementarities in information acquisition in crises, and (iii) complementarities in margin requirements.
This paper studies simultaneous multilateral search (SMS) in over-the-counter (OTC) markets: when searching, an investor contacts several potential counterparties and then trades with the one offering the best quote. Search intensity (how frequently one can search) and search capacity (how many potential counterparties one can contact) affect market qualities differently. Contrasting SMS to bilateral bargaining (BB), the model shows that investors might favor BB over SMS if search intensity is high or in distress. Such preference for BB hurts allocative efficiency and suggests an intrinsic hindrance in the adoption of all-to-all and request-for-quote type of electronic trading in OTC markets.
We characterize the unique equilibrium in an economy populated by strategic CARA investors who trade multiple risky assets with arbitrarily distributed payoffs. We use our explicit solution to study the joint behaviour of illiquidity of option contracts and show that, contrary to the conventional wisdom, option bid-ask spreads may decrease in risk aversion, physical variance, and open interest but increase after earnings announcements. All these predictions are confirmed empirically using a large panel dataset of US stock options.
We consider a market where large investors do not only trade on information about asset fundamentals. When they trade more aggressively, the price becomes less informative. Other investors who learn from prices, in turn, are less concerned about adverse selection and provide more liquidity, causing large investors to trade even more aggressively. This trading complementarity can engender three unconventional results: i) increased competition among large investors makes all investors worse off, ii) more precise private information reduces price informativeness, creating complementarities in information acquisition, and iii) multiple equilibria emerge. Our results have implications for competition and transparency policies in financial markets.
We consider an economy populated by strategic CARA investors who trade multiple risky assets with arbitrarily distributed payoffs. Our solution method reduces finding the equilibrium to solving a linear ordinary differential equation. With non-Gaussian payoffs: (i) asymmetry and nonlinearity of the price response to order imbalances are linked to higher moments of returns, in line with stylized facts; (ii) liquidity may be reduced when risk aversion or uncertainty decreases; (iii) market illiquidity is proportional to its risk- neutral variance; and (iv) illiquidity of individual assets is proportional to the risk-neutral covariance between returns earned by liquidity providers and asset returns.
I analyse liquidity, information efficiency and welfare in a market with large and small traders. Large traders create noise in the price for small traders, and vice versa, due to private value differences across the two groups. More liquidity induces large traders to trade more aggressively, creating more noise for small traders; less informative prices, in turn, incite small traders to provide more liquidity. Implications of this interaction are twofold: (i) an increase in competition between large traders may make all traders worse-off, (ii) an increase in the quality of private information may reduce information efficiency.
I present a model of strategic trading a la Kyle (1989) that does not require the assumption of normally distributed asset payoffs. I propose a constructive solution method: finding the equilibrium reduces to solving a linear ordinary differential equation. With non-normal payoffs, the price response becomes an asymmetric, non-linear function of order size: greater for buys than sells and concave (convex) for small sell (buy) orders when asset payoffs are positively skewed; concave for large sell (buy) orders when payoffs are bounded below (above). The model can speak to key empirical findings and provides new predictions concerning the shape of price impact.
We develop a dynamic general equilibrium model to study how competition among institutional investors affects the stock market characteristics - level, expected return, and volatility. We consider an economy in which multiple fund managers strategically interact with each other, as each manager tries to increase her performance relative to the others. We fully characterize an equilibrium in this economy, and find that a more intense competition is associated with a higher level of the market, lower expected market return, while market volatility is not affected by competition. These findings are broadly consistent with the data.