This paper analyzes the incentives of large shareholders to monitor public corporations. We investigate the hypothesis that a liquid stock market reduces large shareholders’ incentives to monitor because it allows them to sell their stocks more easily. Even though this is true, a liquid market also makes it less costly to hold larger stakes and easier to purchase additional shares. We show that this fact is important if monitoring is costly: market liquidity mitigates the problem that small shareholders free ride on the effort of the large shareholder. We find that liquid stock markets are beneficial because they make corporate governance more effective. IS A LIQUID STOCK MARKET a liability for effective corporate governance? Casual empiricism seems to suggest that a liquid market allows investors to sell out if they receive adverse information about a company, and that, by contrast, a less liquid market forces them to hold on to their investment and to use their votes to influence the company to achieve better returns. A typical example is British Airways ’ experience, when its senior management came under attack for using unfair competitive practices against one of its smaller rivals, Virgin Atlantic. At the time, the Financial Times noted that Fidelity, the second largest shareholder with a holding of 4.5 percent, “has disposed of almost its entire position, and the Prudential and Standard Life stakes have

Theoretical models predict that overcon�dent investors trade excessively. We test this prediction by partitioning investors on gender. Psychological research demonstrates that, in areas such as �nance, men are more overcon�dent than women. Thus, theory predicts that men will trade more excessively than women. Using account data for over 35,000 households from a large discount brokerage, we analyze the common stock investments of men and women from February 1991 through January 1997. We document that men trade 45 percent more than women. Trading reduces men’s net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. It’s not what a man don’t know that makes him a fool, but what he does know that ain’t so. Josh Billings, nineteenth century American humorist It is dif�cult to reconcile the volume of trading observed in equity markets with the trading needs of rational investors. Rational investors make periodic contributions and withdrawals

People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse marketmakers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, and they overreact to salient, anecdotal, and less relevant information. MODELS OF FINANCIAL MARKETS are often extended by incorporating the imperfections that we observe in real markets. For example, models may not consider transactions costs, an important feature of real markets; so Constantinides ~1979!, Leland ~1985!, and others incorporate transactions costs into their models. Just as the observed features of actual markets are incorporated into models, so too are the observed traits of economic agents. In 1738 Daniel Bernoulli noted that people behave as if they are risk averse. Prior to Bernoulli most scholars considered it normative behavior to value a gamble at its expected value. Today, economic models usually assume agents are risk averse, though, for tractability, they are also modeled as risk neutral. In reality, people are not always risk averse or even risk neutral; millions of people engage in regular risk-seeking activity, such as buying lottery tickets. Kahne-

We study an equilibrium in which agents face surprise liquidity shocks and invest in liquid and illiquid riskless assets. The random holding horizon from liquidity shocks makes the return of the illiquid security risky. The equilibrium premium for such risk depends on the constraint that agents face when borrowing against future income; it is insignificant without borrowing constraint, but can be very high with borrowing constraint. Illiquidity, therefore, can have large effects on asset returns when agents face liquidity shocks and borrowing constraints. This result can help us understand why some securities have high liquidity premia, despite low turnover frequency.

: We assess links between China and the rest of emerging Asia. Some commentators have argued that China's apparent devaluation in 1994 may have contributed to the Asian financial crisis. We argue that the devaluation was not economically important: The more-relevant exchange rate was a floating rate that was not devalued, and high Chinese inflation has led to a very sharp real appreciation of the currency. Although in principle, export competition with China could nevertheless have placed pressure on other Asian exporters, we argue that the striking feature of the data is the common movement between export growth from China and from other developing Asian economies. To the extent there is evidence of export competition, it is the period from about 1989 to 1993: China's exchange rate depreciated sharply, Chinese export growth exceeded export growth of other Asian economies, and the composition of Asian exports (measured by export shares of various goods to the United States and...

We propose a dynamic equilibrium model of a multi-asset market with stochastic volatility and transaction costs. Our key assumption is that investors might be forced to liquidate their portfolios when their performance falls below a threshold. This generates a preference for liquidity which is time-varying and increasing with volatility. We show that during volatile times, assets ’ liquidity premia increase, investors become more risk averse, the correlation between the market and the volatility becomes more negative, assets ’ pairwise correlations increase, and the market betas of illiquid assets increase. Moreover, an unconditional CAPM understates the risk of illiquid assets because these assets become riskier when investors are the most risk averse.

This paper presents a model in which investors cannot remain in the market to trade at all times. As a result they have an incentive to set up trading firms or financial market intermediaries (FMI’s) to take over their portfolio while they engage in other activities. Previous research has assumed that such firms act like individuals endowed with a utility function. Here, they are firms that simply take orders from their investors. From this setting emerges a theory of mutual funds and other FMI’s (such as investment houses, banks, and insurance companies) with implications for their trading styles, as well as for their effect on asset prices. The model provides theoretical support for past empirical findings, and provides new empirical predictions, some of which are tested in this paper. JEL Classification: G12, G20Banks, investment houses, and mutual funds have in recent years created a wide array of vehicles that trade on behalf of investors. In 1999, for example, U.S. equity funds managed roughly 6 trillion dollars; in 1990 this number was only 300 billion. Presumably, such financial market intermediaries (henceforth FMI’s) meet some particular investor demand. A number of empirical papers have noted that the plethora of existing financial institutions exhibit a wide range of trading behaviors, many of which are difficult to reconcile with

We report results of an internet experiment designed to test the theory of informational cascades in financial markets. More than 6000 subjects, including a subsample of 267 consultants from an international consulting firm, participated in the experiment. As predicted by theory, we find that the presence of a flexible market price prevents herding. However, the presence of contrarian behavior, which can (partly) be rationalized via error models, distorts prices, and even after 20 decisions convergence to the fundamental value is rare. We also study the effects of transaction costs and the expectations of subjects with respect to future prices. Finally, we look at the behavior of various subsamples of our heterogeneous subject pool.

What are the equilibrium features of a Þnancial market where a sizeable proportion of traders face reputational concerns? This question is central to our understanding of Þnancial markets that are increasingly dominated by institutional investors. We construct a model of delegated portfolio management that captures key features of the US mutual fund industry and embed it in an asset pricing framework. We thus provide a formal model of Þnancial equilibrium with career concerned agents. Fund managers differ in their ability to understand market fundamentals, and in every period investors choose a fund. In equilibrium, the presence of career concerns induces uninformed fund managers to churn, i.e. to engage in trading even when they face a negative expected return. As churning plays the role of noise trading, the asset market displays non-fully informative prices and positive (and high) trading volume. The equilibrium relationship between fund return and net fund ßows displays a skewed shape that is consistent with stylized facts. The robustness of our core results is probed from several angles.

What are the equilibrium features of a dynamic financial market in which traders care about their reputation for ability? We modify a standard sequential trading model to include traders with career concerns. We show that this market cannot be informationally efficient: there is no equilibrium in which prices converge to the true value, even after an infinite sequence of trades. We characterize the most revealing equilibrium of this game and show that an increase in the strength of the traders’reputational concerns has a negative effect on the extent of information that can be revealed in equilibrium but a positive effect on market liquidity.