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 examine how investor sentiment affects the cross-section of stock returns. Theory predicts that a broad wave of sentiment will disproportionately affect stocks whose valuations are highly subjective and are difficult to arbitrage. We test this prediction by studying how the cross-section of subsequent stock returns varies with proxies for beginning-of-period investor sentiment. When sentiment is low, subsequent returns are relatively high on smaller stocks, high volatility stocks, unprofitable stocks, non-dividend-paying stocks, extreme-growth stocks, and distressed stocks, consistent with an initial underpricing of these stocks. When sentiment is high, on the other hand, these patterns attenuate or fully reverse. The results are consistent with predictions and appear unlikely to reflect an alternative explanation based on compensation for systematic risk.

Not necessarily. The fundamental value of a firm increases with uncertainty about average future profitability, and this uncertainty was unusually high in the late 1990s. We calibrate a stock valuation model that includes this uncertainty, and compute the level of uncertainty that is needed to match the observed Nasdaq valuations at their peak. This uncertainty seems plausible because it matches not only the high level but also the high volatility of Nasdaq stock prices. We also show that uncertainty about average profitability has the biggest effect on stock prices when the equity premium is low.

The market dynamics of technology stocks in the late 1990s have stimulated a growing body of theory that analyzes the joint effects of short-sales constraints and heterogeneous beliefs on stock prices and trading volume. This paper examines several implications of these theories using a unique data sample from a market with stringent short-sales constraints and perfectly segmented dual-class shares. The identical rights of the dual-class shares allow us to control for stock fundamentals. We find that trading caused by investors’ speculative motives can help explain a significant fraction of the price difference between the dual-class shares.

In this paper we use data from China’s stock markets to analyze non-fundamental components in stock prices. During the period 1993-2000, several dozen Chinese firms offered two classes of shares: class A, which could only be held by domestic investors, and class B, which could only be traded by foreigners. Despite their identical rights, A-share prices were on average 400 % higher than the corresponding B shares. We use a model of investor overconfidence (Scheinkman and Xiong (2003)) that produces correlations among prices, turnover, and volatility, to explain this premium. By adopting a panel regression method, we find that the turnover rate of A shares is able to explain 20 % of the cross-sectional variation in A-B share premium. We also conduct various specification analyses, and examine the relation between float, turnover rate, and volatility.

Schwartz for helpful suggestions and David Hait (Option Metrics) for providing the options data. We are especially grateful to comments from Owen Lamont, Jeff Wurgler, the anonymous referee and seminar participants at UBC, NYU, USC and the NBER. The views expressed herein are those of the authors and not

This paper examines the choices of collateral made by financial institutions in Canada's large value payment system (LVTS). The management of collateral is complicated by the fact that participants operate across multiple business lines that compete for these scarce resources. The choice of securities, and their related opportunity cost, is determined by the demand for payment services, relative yields and liquidity in individual financial markets, and the size of the pool of liquid assets managed by each financial institution. For short-term needs, participants typically demand Government of Canada issued securities, which can be easily re-deployed to other business needs. Interestingly, an institution’s market making activity in a specific asset class does not affect the likelihood that a security will be pledged or released. Keywords: Fixed-income markets, collateral, banking, convenience yields

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University for useful comments. Part of this research was undertaken while both authors were