Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.”

We review extensive evidence about how psychological biases affect investor behavior and prices. Systematic mispricing probably causes substantial resource misallocation. We argue that limited attention and overconfidence cause investor credulity about the strategic incentives of informed market participants. However, individuals as political participants remain subject to the biases and self-interest they exhibit in private settings. Indeed, correcting contemporaneous market pricing errors is probably not government’s relative advantage. Government and private planners should establish rules ex ante to improve choices and efficiency, including disclosure, reporting, advertising, and default-option-setting regulations. Especially

Motivated by the behavior of internet stock prices in 1998-2000, we present a continuous time equilibrium model of bubbles where overconfidence generates agreements to disagree among agents about asset fundamentals. With a short-sale constraint, an asset owner has an option to sell the asset to other agents when they have more optimistic beliefs. This re-sale option has a recursive structure, that is a buyer of the asset gets the option to resell it, causing a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. The model generates prices that are above fundamentals, excessive trading, and excess volatility. We also give an example where the price of a subsidiary is larger than its parent firm. Our analysis shows that while Tobin's tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility.

author is gratefully acknowledged. All errors are solely our responsibility. On the Role of Arbitrageurs in Rational Markets Price discrepancies, although at odds with mainstream finance, are persistent phenomena in financial markets. These apparent mispricings lead to the presence of “arbitrageurs, ” who aim to exploit the resulting profit opportunities, but whose role remains controversial. This article investigates the impact of the presence of arbitrageurs in rational financial markets. Arbitrage opportunities between redundant risky assets arise endogenously in an economy populated by rational, heterogeneous investors subject to position limits. An arbitrageur, indulging in costless, riskless arbitrage is shown to alleviate the effects of position limits and improve the transfer of risk amongst investors. When the arbitrageur lacks market power, he always takes on the largest arbitrage position possible. When the arbitrageur behaves non-competitively, in that he takes into account the price impact of his trades, he optimally limits the size of his positions due to his decreasing marginal profits. In the case when the arbitrageur is subject to margin requirements and is endowed with capital from outside investors, the size of the arbitrageur’s trades and the capital needed to implement these trades are endogenously solved for in equilibrium.

Given multivariate time series, we study the problem of forming portfolios with maximum mean reversion while constraining the number of assets in these portfolios. We show that it can be formulated as a sparse canonical correlation analysis and study various algorithms to solve the corresponding sparse generalized eigenvalue problems. After discussing penalized parameter estimation procedures, we study the sparsity versus predictability tradeoff and the impact of predictability in various markets.

• Classic case of statistical arbitrage.

Fair value accounting forces institutions to revalue their inventory whenever a new transaction price is observed. An institution facing a balance sheet constraint can have incentives to suspend trading in opaque over-the-counter markets to obstruct further price discovery. This way the asset’s book valuation can be kept artificially high, thereby relaxing the institution’s balance sheet constraint. But, the institution loses direct control of its asset holdings, leading to possible excessive risk exposure. An institution optimally balances this tradeoff when choosing the point beyond which it suspends trading. Outside investors, who do not know at what price the asset would trade, reduce their valuation the longer the asset has not traded. Their expected discount from book value is convex in time since last trade and robust to parameter misspecifications. Keywords: Mark-to-market; Mark-to-model; Level 3 assets; Balance sheet constraints;

This is the first paper to examine the microstructure of how mispricing is created and resolved. We study dual class-shares with equal cash-flow rights, and show that a simple trading strategy exploiting gaps between their prices creates abnormal profits after transactions costs and a battery of conservative robustness checks. Trade data from TAQ shows that investors shift their trading patterns to take advantage of gaps. Contrary to common perception, long-short arbitrage plays a minor part in eliminating gaps, and one-sided trades correct the bulk of them. We also show that the more liquid share class is, more often than not, responsible for the price discrepancies. Our findings have implications for the literature on risky arbitrage and asset pricing more generally. 1

Fair value accounting forces institutions to revalue their inventory whenever a new transaction price is observed. An institution facing a balance sheet constraint can have incentives to suspend trading in opaque over-the-counter markets to obstruct further price discovery. This way the asset’s book valuation can be kept artificially high, thereby relaxing the institution’s balance sheet constraint. But, the institution loses direct control of its asset holdings, leading to possible excessive risk exposure. An institution optimally balances this tradeoff when choosing the point beyond which it suspends trading. Outside investors, who do not know at what price the asset would trade, reduce their valuation the longer the asset has not traded. Their expected discount from book value is convex in time since last trade and robust to parameter misspecifications.

This paper studies cross-sectional determinants of stock returns and order imbalance during five recent episodes of market crashes and subsequent recoveries in the United States in the period 1997-2007. The results indicate that a stock’s volatility, turnover and market beta are important determinants of its return both in the periods of crashes and recoveries. The sign of the relation of returns to these variables is negative during crashes, and reverts to positive during recoveries. Furthermore, crash- and recovery-period returns are associated positively with the contemporaneous changes in order imbalance, reflecting the price impact of selling and buying pressures in the studied periods. Analysis of the cross-sectional determinants of changes in order imbalance reveals that trading patterns in crash periods are dominated by flight to size. The periods of recovery are characterized by flights to stocks with low crashperiod volatility and turnover, and stocks with large crash-period losses. Overall, the evidence suggests that cross-sectional returns in the periods of crisis are determined by (i) the stocks ’ “market sensitivity ” characteristics and (ii) reallocation of resources, i.e. flights, in the market.