welfare economics risk and uncertainty social decisions in risky contexts raise a number of difficult questions such as 1 should social decisions be more or less risk averse than the average person 2 should we try to avoid large catastrophes more than frequent but limited harms with similar expected impact 3 should social decisions be ambiguity averse or stick to the expected utility canon this paper reviews the welfare economics of risk and uncertainty and examines possible answers to these questions based on the pros and cons of utilitarianism ex ante egalitarianism and ex post egalitarianism

speculative investor behavior and learning as traders learn about the true distribution of some asset s dividends a speculative premium occurs as each trader anticipates the possibility of reselling the asset to another trader before complete learning has occurred small differences in prior beliefs lead to large speculative premiums during the learning process this phenomenon helps explain a paradox concerning the pricing of initial public offerings the result casts light on the significance of the common prior assumption in economic models

employer stock and 401 k plans the sharp decline in the stock prices of several firms at which employees held a large fraction of their 401 k plan assets in company stock including enron global crossing lucent and polaroid has sparked a public policy debate about investment options in 401 k plans at many large firms particularly those with retirement saving plans that combine elements of an employee stock ownership plan esop with a traditional 401 k a substantial fraction of defined contribution retirement plan assets are held in company stock such undiversified holdings are a source of concern because they raise the volatility of the retirement wealth for employees and expose some workers to the prospect of very small retirement values holding an undiversified position in employer stock may be particularly costly because of the potential correlation between company stock returns and the value of the worker s human capital which may depend on the company s prospects this paper reviews the extent of undiversified company stock investments in 401 k plans evaluates the cost of such investments from an employee s perspective and discusses a range of policy actions that could address the excessive concentration of retirement plan assets

on option pricing bounds the purpose of this article is to compare the perrakis and ryan bounds of option prices in a single period model with option bounds derived using linear programming it is shown that the upper bounds are identical but that the lower bounds are different a comparison of these bounds together with merton s bounds and the black scholes prices in a lognormal securities market is presented the black scholes 1 option pricing model is preference free its simplicity derives from the continuous trading assumption which enables a portfolio of stock and bonds to be constructed so as to replicate the payouts of the option in an incomplete market with only finite opportunities to revise portfolios no preference free option price can be constructed 3 6 for this case preferencedependent prices can be established rather than place restrictive assumptions on preferences perrakis and ryan pr 5 have recently derived upper and lower bounds for a single and multiple period call option price the development of these bounds is based on the single price law and arbitrage arguments and requires modest assumptions on preferences the bounds exist as equilibrium values given a consensus on stock price distributions in this article we shall develop bounds for option prices based on primitive prices in incomplete markets and compare these bounds to the single period bounds derived by perrakis and ryan towards this goal we first review the pricing approach for primitive securities and proceed to re express the pr bounds as derived from their arbitrage portfolios then using linear programming bounds on option prices are derived linear programming approaches for obtaining relationships among option prices have been investigated garman 2 for example established an algebra for evaluating hedge portfolios using this algebra a one period linear program can be established that provides a way to search for arbitrage opportunities over an infinite number of portfolio strategies one of the features of the algebra is that only one linear program need be solved to determine if riskless arbitrage strategies can be established by investigating the dual of the linear program garman obtained necessary and sufficient conditions for rational option pricing in a one period setting these bounds were shown to be consistent with the bounds determined by merton 4 unlike garman s approach the linear programming approach presented here places constraints on time preferences risk aversion and state probabilities under specific sets of assumptions linear programs are formulated where the objective function to be optimized is the call price minimization and maximi

tax incidence for fragile financial markets abstract standard tax incidence analysis deals with households and firms that buy and sell consumption goods as opposed to financial institutions that buy and sell financial products this paper develops a framework that allows us to study tax incidence on financial markets and applies it to a financial transactions tax a main result is that the tax may contribute to financial distress moreover if the government has to bail out the debtors of failed financial institutions the tax induced increase in bailout costs may be larger than the increase in tax revenue so that the government s overall fiscal position becomes worse

a theory of disclosure in speculative markets this paper presents a theory of disclosure in a market where investors have heterogeneous beliefs and face short sale constraints assets trade above fundamentals reflecting the value of the option to sell to more optimistic investors in the future the initial seller has an incentive to commit to an imprecise disclosure policy despite the negative effect this has on the fundamental value of the asset in order to increase the potential for disagreement and hence the magnitude of the speculative premium i show that there is a strategic complementarity between sellers in their disclosure decisions this explains why financial misreporting and episodes of speculation occur together in waves and demonstrates that the endogenous choice of imprecise disclosure amplifies the extent to which assets are overpriced this paper was accepted by amit seru finance

belief disagreements and collateral constraints belief disagreements have been suggested as a major contributing factor to the recent subprime mortgage crisis this paper theoretically evaluates this hypothesis i assume that optimists have limited wealth and take on leverage so as to take positions in line with their beliefs to have a significant effect on asset prices they need to borrow from traders with pessimistic beliefs using loans collateralized by the asset itself since pessimists do not value the collateral as much as optimists do they are reluctant to lend which provides an endogenous constraint on optimists ability to borrow and to influence asset prices i demonstrate that the tightness of this constraint depends on the nature of belief disagreements optimism concerning the probability of downside states has no or little effect on asset prices because these types of optimism are disciplined by this constraint instead optimism concerning the relative probability of upside states could have significant effects on asset prices this asymmetric disciplining effect is robust to allowing for short selling because pessimists that borrow the asset face a similar endogenous constraint these results emphasize that what investors disagree about matters for asset prices to a greater extent than the level of disagreements when richer contracts are available relatively complex contracts that resemble some of the recent financial innovations in the mortgage market endogenously emerge to facilitate betting

a welfare criterion for models with distorted beliefs this paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs instead of taking a stand on whose belief is correct our criterion asserts an allocation to be belief neutral ine cient if it is ine cient under any convex combination of agents beliefs while this criterion gives an incomplete ranking of social allocations it can identify negative sum speculation in a broad range of prominent models with distorted beliefs

trade with heterogeneous prior beliefs and asymmetric information no trade theorems have shown that new information will not lead to trade when agents share the same prior beliefs this paper explores the structure of no trade theorems with heterogeneous prior beliefs it is shown how different notions of efficiency under asymmetric information ex ante interim ex post are related to agents prior beliefs as well as incentive compatible and public versions of those efficiency concepts these efficiency results are used to characterize necessary and sufficient conditions on agents beliefs for no trade theorems in different trading environments

toward choice theoretic foundations for behavioral welfare economics interest in behavioral economics has grown in recent years stimulated largely by accumulating evidence that the standard model of consumer decision making provides an inadequate positive description of human behavior behavioral models are increasingly finding their way into policy evaluation which inevitably involves welfare analysis no consensus concerning the appropriate standards and criteria for behavioral welfare analysis has emerged yet this paper summarizes our effort to develop a unified framework for behavioral welfare economics for a detailed discussion see bernheim and rangel 2007 one that can be viewed as a natural extension of standard welfare economics standard welfare analysis is based on choice not on utility or preferences in its simplest form it instructs the planner to respect the choices an individual would make for himself the guiding normative principle is an extension of the libertarian deference to freedom of choice which takes the view that it is better to give a person the thing he would choose for himself rather than something that someone else would choose for him we show that it is possible to extend the standard choice theoretic approach to welfare analysis to situations where individuals make inconsistent choices which are prevalent in behavioral economics

securitization bubbles structured finance with disagreement about default risk abstract an additional reason for the structured finance boom of the 2000s may have been disagreement about default risk of collateral assets when risk neutral investors disagree about average default probabilities structuring collateral cash flow raises prices by concentrating optimists demand on risky tranches with disagreement about default correlation low correlation investors believe in diversification and pay high prices for senior tranches they deem riskless high correlation investors value junior tranches they expect to pay whenever aggregate conditions are good risk aversion and short selling through credit default swaps reduce the prices of both pass through and structured securitizations but may increase the return to tranching

a case for incomplete markets we propose a new welfare criterion that allows us to rank alternative financial market structures in the presence of belief heterogeneity we analyze economies with complete and incomplete financial markets and or restricted trading possibilities in the form of borrowing limits or transaction costs we describe circumstances under which various restrictions on financial markets are desirable according to our welfare criterion

ambiguity aversion and incompleteness of contractual form subjective uncertainty is characterized by ambiguity if the decision maker has an imprecise knowledge of the probabilities of payoff relevant events in such an instance the decision maker s beliefs are better represented by a set of probability functions than by a unique probability function an ambiguity averse decision maker adjusts his choice on the side of caution in response to his imprecise knowledge of the odds the non additive expected utility model allows a formal characterization of such behaviour using this model this paper shows that ambiguity aversion can explain the existence of incomplete contracts the setting for the demonstration is the investment hold up model which has been the focus of much of the recent research on the implications of incomplete contracts

shrouded attributes consumer myopia and information suppression in competitive markets bayesian consumers infer that hidden add on prices e g the cost of ink for a printer are likely to be high prices if consumers are bayesian firms will not shroud information in equilibrium however shrouding may occur in an economy with some myopic or unaware consumers such shrouding creates an inefficiency which firms may have an incentive to eliminate by educating their competitors customers however if add ons have close substitutes a curse of debiasing arises and firms will not be able to profitably debias consumers by unshrouding add ons in equilibrium two kinds of exploitation coexist optimizing firms exploit myopic consumers through marketing schemes that shroud high priced add ons in turn sophisticated consumers exploit these marketing schemes it is not possible to profitably drive away the business of sophisticates it is also not possible to profitably lure either myopes or sophisticates to nonexploitative firms we show that informational shrouding flourishes even in highly competitive markets even in markets with costless advertising and even when the shrouding generates allocational inefficiencies

speculation and risk sharing with new financial assets while the traditional view of nancial innovation emphasizes the risk sharing role of new nancial assets belief disagreements about these assets naturally lead to speculation which represents a powerful economic force in the opposite direction this paper investigates the eect of nancial innovation on portfolio risks in an economy when both the risk sharing and the speculation forces are present financial assets provide hedging services but they are also subject to speculation because traders do not necessarily agree about their payos i de ne the average variance of traders net worths as a measure of portfolio risks for this economy and i decompose it into two components the uninsurable variance de ned as the average variance that would obtain if there were no belief disagreements and the speculative variance de ned as the residual variance that results from speculative trades based on belief disagreements financial innovation always decreases the uninsurable variance because new assets increase the possibilities for risk sharing my main result shows that nancial innovation also always increases the speculative variance this is true even if traders completely agree about the payos of new assets the intuition behind this result is the hedge more bet more eect traders use new assets to hedge their bets on existing assets which in turn enables them to place larger bets and take on greater risks my second set of results concern endogenous nancial innovation when belief disagreements are su ciently large a pro t seeking market maker introduces assets that maximize the average variance among all possible choices completely disregarding the risk sharing motive for nancial innovation my third set of results concern a calibration of the model in the context of the gdp indexed assets proposed by athanasoulis and shiller 2001 when traders have reasonable amounts of belief disagreements these assets would have the unintended consequence of increasing their consumption risks

utilitarian preferences with multiple priors this paper proposes a method for aggregating individual preferences in the context of uncertainty individuals are assumed to abide by savage s model of subjective expected utility in which everyone has his her own utility and subjective probability disagreement on probabilities among individuals gives rise to uncertainty at the societal level and thus society may entertain a set of probabilities rather than only one we assume that social preference admits a maxmin expected utility representation in this context two pareto type conditions are shown to be equivalent to social utility being a weighted average of individual utilities and the social set of priors containing only weighted averages of individual priors thus society respects consensus among individuals beliefs and does not add ambiguity beyond disagreement on beliefs we also deal with the case in which society does not rule out any individual belief

option pricing bounds in discrete time upper and lower bounds are derived for call options traded at discrete intervals these bounds are independent of assumptions on the stock price distribution other than a restriction satisfied by the stock being non negative beta the development of the bounds relies on the single price law and arbitrage arguments both single period and multiperiod results are produced and put option bounds follow by extension the bounds exist as equilibrium values given a consensus on stock price distribution they are also valid for empirical studies being adjustable for dividends and commissions following the impetus of the black scholes pricing model the majority of option analyses have been in continuous time such approaches have relied on the formation of perfect riskless hedges involving the option its underlying security and a riskless asset since the hedge must be continuously revised and maintained while actual trading opportunities are discrete this crucial assumption limits the accuracy and applicability of the black scholes and related formulae in fact the black scholes formula can only be considered as a valid approximation to the discrete time solution merton 8 p 663 while the closeness of that approximation has not been ascertained in general 1 earlier discrete models such as boness 3 and samuelson 12 have been succeeded by those of brennan 5 cox et al 6 and rubinstein 11 in which distributional restrictions are imposed on share returns usually the discrete formula converges to the black scholes expression under appropriate limit conditions using the rubinstein 11 approach we derive upper and lower bounds for option prices with both a general price distribution and discrete trading opportunities the bounds are functions of the share and exercise prices the riskless rate of interest the distribution of the share price change per period and the number of periods of expiration of the option the lower bound is tighter than that of merton 7 derived from more general arbitrage considerations while being less exact than the results already mentioned for restricted distributions

intertemporal asset pricing with heterogeneous beliefs abstract we examine the behaviour of the interest rate asset prices and asset holdings in an economy with heterogeneous rationally updated beliefs about the expected rate of production growth the equilibrium interest rate is a weighted average of the interest rates that would prevail in economies populated by homogeneous agents with the beliefs of the respective agents in the heterogeneous model the weights are given by the fractions of total wealth held financial innovation affects the dynamics of allocations and prices but preserves the aggregate output process and the structure of equilibrium asset prices also display the wealth weighted average characterization journal of economic literature classification numbers c60 d52 d91 g12

the pareto principle of optimal inequality the pareto principle is often viewed as a mild requirement compatible with a variety of value judgements in particular it is generally thought that it can accommodate different views on the desirable degree of equality we show that this is generally not true in intertemporal models where some uncertainty prevails to do so we formalize the concept of inequality aversion we show that different degrees of inequality aversion are not possible in typical models of time consistent dynamic decision under uncertainty

a more robust definition of subjective probability the goal of choice theoretic derivations of subjective probability is to separate a decisionmaker s underlying beliefs subjective probabilities of events from their preferences attitudes toward risk classical derivations have all relied upon some form of the marschak samuelson independence axiom or the savage sure thing principle which imply that preferences over lotteries conform to the expected utility hypothesis this paper presents a choice theoretic derivation of subjective probability in a savage type setting of purely subjective uncertainty which neither assumes nor implies that the decisionmaker s preferences over lotteries necessarily conform to the expected utility hypothesis copyright 1992 by the econometric society

the impossibility of a paretian rational a bayesian perspective abstract if a group takes a collective decision on the basis of separately aggregated group judgments on the probabilities of independent events there may not exist any anonymous aggregation rule that respects individuals unanimous outcome preferences at all profiles of beliefs

maxmin expected utility over savage acts with a set of priors abstract this paper provides an axiomatic foundation for a maxmin expected utility over a set of priors mmeu decision rule in an environment where the elements of choice are savage acts this characterization complements the original axiomatization of mmeu developed in a lottery acts or anscombe aumann framework by i gilboa and d schmeidler 1989 j math econ 18 141 153 mmeu preferences are of interest primarily because they provide a natural and tractable way of modeling decision makers who display an aversion to uncertainty or ambiguity the novel axioms are formulated using standard sequence techniques which allow cardinal properties of utility to be expressed directly through preferences journal of economic literature classification number d81

eliciting von neumann morgenstern utilities when probabilities are distorted or unknown this paper proposes a new method the gamble tradeoff method for eliciting utilities in decision under risk or uncertainty the elicitation of utilities to be used in the expected utility criterion turns out to be possible even if probabilities are ambiguous or unknown a disadvantage of the tradeoff method is that a few more questions usually must be asked to clients also the lotteries that are needed are somewhat more complex than in the certainty equivalent method or in the probability equivalent method the major advantage of the tradeoff method is its robustness against probability distortions and misconceptions which constitute a major cause of violations of expected utility and generate inconsistencies in utility elicitation thus the tradeoff method retains full validity under prospect theory rank dependent utility and the combination of the two i e cumulative prospect theory the tradeoff method is tested for monetary outcomes and for outcomes describing life duration we find higher risk aversion for life duration but the tradeoff method elicits similar curvature of utility apparently the higher risk aversion for life duration is due to more pronounced deviations from expected utility

overcoming adverse selection how public intervention can restore market functioning as illustrated by liquidity support equity injections and asset repurchases in financial crises and by imf credit lines to countries authorities often intervene in orderto revive markets that have dried up or to create newones in suchsituations agents participate only if they receive from the governmental scheme more than in the marketplace while the market outcome depends on who joins the scheme the paper provides a first analysis of market jumpstarting and its two way interaction between mechanism design and participation constraints in the model sellers in need of cash have private information about the value of their legacy asset the absence of buyer confidence forces authorities to intervene to jump start the market we characterize the optimal intervention and draw two main implications first the government should clean up the market through buybacks of the weakest assets and then through some equity injections and leave the agents with the strongest legacy assets to the market in particular authorities should not substitute fully for the market even when they have no comparative disadvantage in acquiring assets or shares thereof second the government creates its own competition by cleaning up the market from its most toxic pieces at the optimal intervention the government always strictly overpays for the legacy asset yet and unlike what would be suggested by coasian profit evasion the existence of a later market imposes no welfare cost while it is cast in a public intervention context the analysis of mechanismdependent reservation utilities also admits important private sector applications

ambiguity and the corporation group disagreement and underinvestment abstract we study a dynamic corporate investment problem where decisions have to be made collectively by a group of agents holding heterogeneous beliefs and adhering to a utilitarian governance mechanism in which each agent has a given influence in the decision in this setting we show that i group decisions are typically dynamically inconsistent ii dynamic inconsistency leads to inefficient underinvestment and iii the ability to trade securities among insiders or with outsiders may restore efficient investment decisions but it may in some cases lead to inefficient overinvestment our theory can help explain the empirical evidence on the effect of diversity of groups such as corporate boards on firms outcomes and more generally on the difference between group and individual behavior

restoring rational choice the challenge of consumer financial regulation abstract this lecture considers the case for consumer financial regulation in an environment where many households lack the knowledge to manage their financial affairs effectively the lecture argu

robust permanent income and pricing i suppose there exists an extremely powerful and if i may so speak malignant being whose whole endeavours are directed toward deceiving me rene descartes meditations ii 1

a definition of uncertainty aversion a definition of uncertainty or ambiguity aversion is proposed it is argued that the definition is well suited to modelling within the savage as opposed to anscombe and aumann domain of acts the defined property of uncertainty aversion has intuitive empirical content behaves well in specific models of preference multiple priors and choquet expected utility and is tractable tractability is established through use of a novel notion of differentiability for utility functions called eventwise differentiability

debt financing in asset markets short term debt such as overnight repurchase agreements and commercial paper was heavily used by financial institutions to fund their investment positions during the asset market boom preceding the financial crisis of 2007 2008 and later played a major role in leading to the distress of these institutions during the crisis what explains the popularity of short term debt in financing asset market investments geanakoplos 2010 presents a dynamic model of the joint equilibrium of asset markets and credit markets in which optimistic buyers of a risky asset use the asset as collateral to raise debt financing from less optimistic creditors the asset s collateral value depends on the marginal creditor s asset valuation and determines the buyers purchasing capacity to bid up the asset price geanakoplos posits that short term debt allows the asset buyers to maximize riskless leverage 1 short term debt however exposes the asset buyers to rollover risk e g acharya gale and yorulmaker 2011 and he and xiong 2012 forthcoming which is reflected in the fact that the asset buyers in geanakoplos model may not be able to obtain refinancing after a negative fundamental shock as a result they are forced to transfer their asset holdings to the

comment on the intended and unintended consequences of financial market regulations a general equilibrium analysis by adrian buss bernard dumas raman uppal and grigory vilkov

upper and lower bounds of put and call option value stochastic dominance approach applying stochastic dominance rules with borrowing and lending at the risk free interest rate we derive upper and lower values for an option price for all unconstrained utility functions and alternatively for concave utility functions the derivation of these bounds is quite general and fits any kind of stock price distribution as long as it is characterized by a nonnegative beta transaction costs and taxes can be easily incorporated in the model presented here since investors are not required to revise their portfolios continuously the price that is paid for this generalization is that a range of values rather than a unique value is obtained in the last decade there has been an increasing interest in the options market by both academicians and practitioners the most well known valuation models are the black scholes 4 model the jump stochastic process model see cox and ross 6 the binomial model see cox ross and rubinstein 7 rendleman and bartler 19 and sharpe 22 and rubinstein s discrete model 21 recently perrakis and ryan 18 using rubinstein s approach have derived upper and lower bounds for option prices the relative pricing theory of contingent claims differs in the continuous time and discrete time models in a continuous time framework the instantaneous expected rate of return of the option and that of the underlying stock must follow a certain market equilibrium condition in this case the equilibrium condition is easily determined by a continuous hedging strategy in the discrete time case there is no hedging strategy to provide a simple relationship between the option and the stock price however for a given value distribution of the stock the value distribution of the option is uniquely determined by the option exercise price and this suggests some possible relationships between the stock and option values

regulation of trades based on differences in beliefs abstract some trades based on differences in beliefs might cause more harm than good should they be restricted if yes how we propose three properties ensuring that regulation does not prevent beneficial trade and is consistent unanimity the regulator should not object to trades with identical beliefs merge proofness of autarky if the regulator does not object to finitely many unrelated trades all with identical beliefs then it should not object to the mere juxtaposition of the trades and independence of irrelevant trade if the regulator does not object to the juxtaposition of two unrelated trades then it should not object to any of the two trades standing alone we show that there is a unique policy having these three properties namely laissez faire

ex ante and ex post welfare optimality under uncertainty it is widely believed by economic theorists that if there were no transactions costs and if all information about the economy were perfectly shared by all then arrow debreu contingent commodity markets should bring about an ideal allocation the basis for this belief seems clear we have the two efficiency theorems of welfare economics which assure us that in the absence of external effects any competitive allocation is pareto efficient and that any pareto efficient allocation is competitive provided that appropriate lump sum transfers are made of course there are some reservations that need to be made local satiation and non convexities are well known to cause problems but these are not the problems i wish to discuss here to return to the usual argument the next step involves noticing how with contingent commodity markets the efficiency theorems of welfare economics carry over to an economy with uncertainty as explained for instance in chapter 7 of debreu s theorpj of value the fundamental value judgment that gives these efficiency theorems their normative interest is what may be called consumer sovereignty it is an assumption that the social welfare ordering should respect the preferences that govern consumers market behaviour it is a serious value judgment more serious than most economists have been prepared to concede but its seriousness increases when there is uncertainty we know full well that individuals misperceive the probabilities of certain events assuming that they even perceive any probabilities at all see for example kahneman and tversky 1979 nor are we always willing to accept as appropriate the attitudes to risk of individuals who seem either extremely reckless or extremely cautious societies are often willing to make some gestures towards property owners who have not insured themselves adequately against damage from fire flood or tempest and not just because of imperfect insurance markets or even misperceptions of probabilities in addition the inequalities of income that arise when some individuals take more risks than others are not necessarily seen to be desirable particularly if an individual has undertaken a useful but risky activity and has a very low income as a result of failure such gestures are examples of contingent lump sum transfers it seems clear that if such transfers occur to a sufficient extent they could supplant completely the securities markets which are usually sufficient to bring about pareto efficiency they may even be able to go further and correct the imperfections of an arrow debreu market allocation when individuals do misperceive probabilities or else have wrong attitudes to risk this is the main question i wish to consider here the idea that consumer sovereignty should not always extend to economies with uncertainty is not new it can be found in work by diamond 1967 dr6ze

bubbles crashes and endogenous expectations in experimental spot asset markets1 spot asset trading is studied in an environment in which all investors receive the same dividend from a known probability distribution at the end of each of t 15 or 30 trading periods fourteen of twenty two experiments exhibit price bubbles followed by crashes relative to intrinsic dividend value when traders are experienced this reduces but does not eliminate the probability of a bubble the regression of changes in mean price on lagged excess bids number of bids minus the number of offers in the previous period p pt a f b 1 o l supports the hypothesis that a e d the one period expected value of the dividend and that f 0 where excess bids is a surrogate measure of excess demand arising from homegrown capital gains losses expectations thus when bt 1 o goes to zero we have convergence to rational expectations in the sense of fama 1970 that arbitrage becomes unprofitable the observed bubble phenomenon can also be interpreted as a form of temporary myopia tirole 1982 from which agents learn that capital gains expectations are only temporarily sustainable ultimately inducing common expectations or priors tirole 1982 four of twenty six experiments all using experienced subjects yield outcomes that appear to the chart s eye to converge early to rational expectations although even in these cases we get 0 and small price fluctuations of a few cents that invite scalping

benefit cost analysis for financial regulation calls for benefit cost analysis in rule making based on the dodd frank wall street reform act have revealed a paucity of work on allocative efficiency in financial markets we propose three principles to help fill this gap first we highlight the need for quantifying the statistical cost of a crisis to trade off the risk of a crisis against loss of growth during good times second we propose a framework quantifying the social value of price discovery and highlighting which arbitrages are over and under supplied from a social perspective finally we distinguish between insurance benefits and gambling facilitation harms of market completion

leverage cycles and the anxious economy ing opportunities for emerging economies their access to international markets has turned out to be very volatile with frequent periods of market closures even worse as we will show emerging economies with sound fundamentals are the ones that issue less debt during these closures the goal of this paper is to present a theory of asset pricing that will shed light on the problems of emerging assets like emerging markets that are not yet mature enough to be attractive to the general public their marginal buyers are liquidity constrained investors with small wealth relative to the whole economy who are also marginal buyers of other risky assets we will use our theory to argue that the periodic problems faced by emerging asset classes are sometimes symptoms of what we call a global anxious economy rather than of their own fundamental weaknesses

option volume and stock prices evidence on where informed traders trade this paper investigates the informational role of transactions volume in options markets we develop an asymmetric information model in which informed traders may trade in option or equity markets we show conditions under which informed traders trade options and we investigate the implications of this for the linkage between markets our model predicts an important informational role for the volume of particular types of option trades we empirically test our model s hypotheses with intraday option data our main empirical result is that negative and positive option volumes contain information about future stock prices the information content of trading activity is a subject of widespread interest if trades are correlated with private information then the outcome of the transaction process may portend future movements in price the extension of trading to different venues or to derivative instruments however means that this link between transactions and information need not be easily discernible if there are alternative markets in which informed traders can profit from their information then where informed traders choose to trade may have important implications not only for security p rice movements but for the behavior of related prices as well this suggests that transactions in derivative markets may be an important predictor of future security price movements in this paper we investigate the informational role of transactions volume in options markets for some readers this focus may seem puzzling an option is a derivative security so its price should be dictated unilaterally by the behavior of the stock price this unidirectional linkage is only true however in complete markets if information is impounded into prices by trading then the ability of informed traders to transact in options markets mearns

a risk centric model of demand recessions and speculation we provide a continuous time risk centric representation of the new keynesian model which we use to analyze the interactions between asset prices financial speculation and macro economic outcomes when output is determined by aggregate demand in principle interest rate policy is highly effective in dealing with shocks to asset valuations however in practice monetary policy faces a wide range of constraints if these constraints are severe a decline in risky asset valuations generates a demand recession this reduces earnings and generates a negative feedback loop between asset prices and aggregate demand in the recession phase average beliefs matter not only because they affect asset valuations but also because they determine the strength of the amplification mechanism in the ex ante boom phase belief disagreements or heterogeneous asset valuations matter because they induce investors to speculate this speculation exacerbates the crash by reducing high valuation investors wealth when the economy transitions to recession which depresses wealth weighted average beliefs macroprudential policy that restricts speculation in the boom can pareto improve welfare by increasing asset prices and aggregate demand in the recession

heterogeneous expectations and bond markets this paper presents a dynamic equilibrium model of bond markets in which two groups of agents hold heterogeneous expectations about future economic conditions the heterogeneous expectations cause agents to take on speculative positions against each other and therefore generate endogenous relative wealth fluctuation the relative wealth fluctuation amplifies asset price volatility and contributes to the time variation in bond premia our model shows that a modest amount of heterogeneous expectations can help explain several puzzling phenomena including the excessive volatility of bond yields the failure of the expectations hypothesis and the ability of a tent shaped linear combination of forward rates to predict bond returns the author 2009 published by oxford university press on behalf of the society for financial studies all rights reserved for permissions please email journals permissions oxfordjournals org oxford university press

beyond revealed preference choice theoretic foundations for behavioral welfare economics we propose a broad generalization of standard choice theoretic welfare economics that encompasses a wide variety of nonstandard behavioral models our approach exploits the coherent aspects of choice that those positive models typically attempt to capture it replaces the standard revealed preference relation with an unambiguous choice relation roughly x is strictly unambiguously chosen over y written xp y iff y is never chosen when x is available under weak assumptions p is acyclic and therefore suitable for welfare analysis it is also the most discerning welfare criterion that never overrules choice the resulting framework generates natural counterparts for the standard tools of applied welfare economics and is easily applied in the context of specific behavioral theories with novel implications though not universally discerning it lends itself to principled refinements

food scares in an uncertain world we develop a model that explains the stylized facts of food scares an immediate and sharp decline in consumption of the product followed by a slow and frequently partial recovery of demand after the scare passes the model is used in conjunction with the natural experiment afforded by the mad cow crisis to elicit empirical information on decision makers perception of uncertainty our theoretical and quantitative results suggest that observed behavior is consistent with sharp changes in beliefs and the presence of knightian uncertainty as measured by the degree of imprecision in our model

financial innovation and portfolio risks i illustrate the effect of financial innovation on portfolio risks by using an example with risk sharing needs and belief disagreements i consider two types of innovation product innovation formalized as an expansion of new financial assets and process innovation formalized as a reduction in transaction costs when belief disagreements are large both types of innovation increase portfolio risks moreover endogenous financial innovation is directed towards speculative assets that increase portfolio risks

the intended and unintended consequences of financial market regulations a general equilibrium analysis in a production economy with trade in financial markets motivated by the desire to share labor income risk and to speculate we show that speculation increases volatility of asset returns and investment growth increases the equity risk premium and reduces welfare regulatory measures such as constraints on stock positions borrowing constraints and the tobin tax have similar effects on financial and macroeconomic variables borrowing limits and a financial transaction tax improve welfare because they substantially reduce speculative trading without impairing excessively risk sharing trades

asset float and speculative bubbles we model the relationship between asset float tradeable shares and speculative bubbles investors with heterogeneous beliefs and short sales constraints trade a stock with limited float because of insider lockups a bubble arises as price overweighs optimists beliefs and investors anticipate the option to resell to those with even higher valuations the bubble s size depends on float as investors anticipate an increase in float with lockup expirations and speculate over the degree of insider selling consistent with the internet experience the bubble turnover and volatility decrease with float and prices drop on the lockup expiration date

differences of opinion and international equity markets we develop an international financial market model in which domestic and foreign residents differ in their beliefs about the information content in public signals we determine how informational advantages of domestic investors in the interpretation of home public signals affect equity markets we evaluate the ability of our model to generate four international finance anomalies i the co movement of returns and capital flows ii home equity preference iii the dependence of firm returns on home and foreign factors and iv abnormal returns around foreign firm cross listing in the home market their relationships with empirical differences of opinion proxies are consistent with the model received january 15 2011 editorial decision may 16 2016 by editor geert bekaert

when transparency improves must prices reflect fundamentals better no in the presence of speculative opportunities investors can learn about both asset fundamentals and the beliefs of other traders we show that this learning exhibits complementarity learning more along one dimension increases the value of learning about the other as a result regulatory changes may be counterproductive first increasing transparency i e making fundamental information cheaper to acquire can make prices less informative when investors respond by learning relatively more about others second public disclosures discourage private learning about fundamentals while encouraging information acquisition about others accordingly disclosing more fundamental information can decrease overall informational efficiency by decreasing price informativeness received april 20 2016 editorial decision september 30 2017 by editor itay goldstein

decreasing absolute risk aversion and option pricing bounds in this paper efficient bounds for the price of a call option are obtained using the decreasing absolute risk aversion dara dominance rule such lower and upper bounds are obtained minimizing and maximizing respectively the objective function of a nonlinear optimization problem an explicit formula related to an exponential utility function is given for the special case of three states of nature a large number of experiments have been carried out and the numerical results support the conjecture that the same formula holds for problems with a number of states n 3 moreover dara bounds are more efficient than the bounds obtained using different criteria

robust social decisions we propose and operationalize normative principles to guide social decisions when individuals potentially have imprecise and heterogeneous beliefs in addition to conflicting tastes or interests to do so we adapt the standard pareto principle to those preference comparisons that are robust to belief imprecision and characterize social preferences that respect this robust principle we also characterize a suitable restriction of this principle the former principle provides stronger guidance when it can be satisfied when it cannot the latter always provides minimal guidance

effects of financial innovations on market volatility when beliefs are heterogeneous abstract consider a model with two logarithmic utility maximizer agents that observe aggregate consumption but disagree about its expected rate of change markets are incomplete we first show that volatility of the interest rate in an economy with additional information is higher in a complete markets economy with no additional information there are two differences in volatility with the previous the first one due to the increase in volatility of the wealth share of the individuals is always positive the second difference is the change in covariance between the components of the interest rate volatility and can be positive or negative

neglected risks financial innovation and financial fragility abstract we present a standard model of financial innovation in which intermediaries engineer securities with cash flows that investors seek but modify two assumptions first investors and possibly intermediaries neglect certain unlikely risks second investors demand securities with safe cash flows financial intermediaries cater to these preferences and beliefs by engineering securities perceived to be safe but exposed to neglected risks because the risks are neglected security issuance is excessive as investors eventually recognize these risks they fly back to the safety of traditional securities and markets become fragile even without leverage precisely because the volume of new claims is excessive

arrested development theory and evidence of supply side speculation in the housing market this paper incorporates speculation into the standard supply and demand framework used to analyze housing booms and busts speculation reverses the common intuition that elastic housing supply attenuates housing booms housing market frictions make land a more attractive speculative investment than housing as a result undeveloped land both facilitates construction and intensies

financial innovation and asset price volatility we compare asset prices in an overlapping generations model for incomplete and complete markets individuals within a generational cohort have heterogeneous beliefs about future states of the economy and thus would like to make bets against each other in the incomplete markets economy agents cannot make such bets asset price volatility is very small the situation changes dramatically when markets are completed through financial innovations as the set of available securities now allows agents with different beliefs to place bets against each other wealth shifts across agents and generations such changes in the wealth distribution lead to substantial asset price volatility

survival and long run dynamics with heterogeneous beliefs under recursive preferences i analytically characterize the long run behavior of an economy with two types of agents who differ in their beliefs and are endowed with homothetic recursive preferences agents with more incorrec

overconfidence insurance and paternalism it is well known that when agents are fully rational compulsory public insurance may make all agents better off in the rothschild and stiglitz 1976 model of insurance markets we find that when sufficiently many agents underestimate their personal risks compulsory insurance makes low risk agents worse off hence behavioral biases may weaken some of the well established rationales for government intervention based on asymmetric information

how do we know that real wages are too high it is common belief that the wages that we observe are above the level that would prevail in a competitive labour market and also it is common to believe that wage moderation should be encouraged as a way to keep unemployment down this paper considers whether we can have confidence in these beliefs it presents a number of models designed to cast doubt on the conventional wisdom first we show that in an efficiency wage model in which there is involuntary unemployment a binding minimum wage may increase employment we then present a general equilibrium matching model in which there is involuntary unemployment but wages are below market clearing levels and raising wages can reduce unemployment we then consider the empirical evidence on employment and wage determination to argue that it is just as consistent with this model as with models in which wages are at or above market clearing levels

on multiple discount rates we propose a theory of intertemporal choice that is robust to specific assumptions on the discount rate one class of models requires that one utility stream be chosen over another if and only if its discounted value is higher for all discount factors in a set another model focuses on an average discount factor yet another model is pessimistic and evaluates a flow by the lowest available discounted value

cross hedging strategies between cds spreads and option volatility during crises abstract this paper presents a joint analysis of the term structure of credit default swap cds spreads and the implied volatility surface for five european countries from 2007 to 2012 a sample period covering both the global financial crisis gfc and the european debt crisis we analyze to which extent effective cross hedges can be performed between the credit and equity derivatives markets during these two crises we find that during a global crisis a breakdown of the relationship between credit risk and equity volatility may occur jeopardizing any cross hedging strategy which happened during the gfc this stands in sharp contrast to the more localized european debt crisis during which this fundamental relationship was preserved despite turbulent market conditions for both the cds and volatility markets

ambiguity made precise a comparative foundation the theory of subjective expected utility has been recently extended to allow ambiguity to matter for choice we propose a notion of absolute ambiguity aversion by building on a notion of comparative ambiguity aversion we characterize it for a preference model which encompasses some of the most popular models in the literature we next build on these ideas to provide a definition of unambiguous act and event and show the characterization of the latter as an illustration we consider the classical ellsberg 3 color urn problem and find that the notions developed in the paper provide intuitive answers journal of economic literature classification number d81

personal experiences and expectations about aggregate outcomes using novel survey data we document that individuals extrapolate from recent personal experiences when forming expectations about aggregate economic outcomes recent locally experienced house price movements affect expectations about future u s house price changes and higher experienced house price volatility causes respondents to report a wider distribution over expected u s house price movements when we exploit within individual variation in employment status we find that individuals who personally experience unemployment become more pessimistic about future nationwide unemployment the extent of extrapolation is unrelated to how informative personal experiences are is inconsistent with risk adjustment and is more pronounced for less sophisticated individuals

inequality aversion and risk aversion this note shows that for two social welfare functions which are inequality averse and anonymous if one is more inequality averse than the other it induces a more risk averse household through optimal sharing than the other we present examples showing that this comparative static can be reversed if either the property of inequality aversion or anonymity is dropped

utilitarian aggregation of beliefs and tastes harsanyi s utilitarianism is extended here to savage s framework we formulate a pareto condition that implies that both society s utility function and its probability measure are linear combinations of those of the individuals an indiscriminate pareto condition has been shown to contradict linear aggregation of beliefs and tastes we argue that such a condition is not compelling society should not necessarily endorse a unanimous choice when it is based on contradictory beliefs our pareto condition is restricted to choices that involve identical beliefs only

consensus consumer and intertemporal asset pricing with heterogeneous beliefs le fichier attache est egalement edite dans les cahier de la chaire les particuliers face aux risques de l institut de finance de dauphine cahier n 7 mars 2007

no betting pareto dominance we argue that the notion of pareto dominance is not as compelling in the presence of uncertainty as it is under certainty in particular voluntary trade based on differences in tastes is commonly accepted as desirable because tastes cannot be wrong by contrast voluntary trade based on incompatible beliefs may indicate that at least one agent entertains mistaken beliefs we propose and characterize a weaker no betting notion of pareto domination which requires on top of unanimity of preference the existence of shared beliefs that can rationalize such preference for each agent

fair management of social risk we provide a general method for extending social preferences defined for riskless economic environments to the context of risk and uncertainty we apply the method to the problems of managing unemployment allowances in the context of macroeconomic fluctuations and catastrophic risks in the context of climate change the method guarantees ex post fairness and pays attention to individuals risk attitudes while ensuring rationality properties for social preferences revisiting basic ideas from harsanyi s celebrated aggregation theorem harsanyi 1955 the social preferences that we obtain do not always take the form of an expected utility criterion but they always satisfy statewise dominance when we require social preferences to be expected utilities we obtain a variant of harsanyi s result under a weak version of the pareto principle and a maximin criterion under a stronger pareto requirement whenever the ex post social ordering does not depend on people s risk attitudes we also show how non expected utility individual preferences can be accommodated in the approach

asymmetric information and options in an extension of the kyle 1985 model of continuous insider trading it is shown that asymmetric information can make it impossible to price options by arbitrage even when an option would appear to be redundant its introduction into the market can cause the volatility of the underlying asset to become stochastic this eliminates the potential for dynamically replicating the option the change in the price process of the asset reflects a change in the information transmitted by volume and prices when the option is traded article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

resource egalitarianism with a dash of efficiency abstract we study the problem of defining inequality averse social orderings over allocations of commodities when individuals have different preferences we formulate a notion of egalitarianism based on the axiom that any dominance between consumption bundles should be reduced this dominance aversion requirement is compatible with consensus a version of the pareto principle saying that an allocation y is better than x whenever everybody finds that everyone s bundle at y is better than at x we characterize a family of multidimensional leximin orderings satisfying dominance aversion and consensus

the chinese warrants bubble in 2005 2008 over a dozen put warrants traded in china went so deep out of the money that they were almost certain to expire worthless nonetheless each warrant was traded more than three times each day at substantially inflated prices this bubble is unique in that the underlying stock prices make warrant fundamentals publicly observable and that warrants have predetermined finite maturities this sample allows us to examine a set of bubble theories in particular our analysis highlights the joint effects of short sales constraints and heterogeneous beliefs in driving bubbles and confirms several key findings of the experimental bubble literature jel g12 g13 o16 p34

financial complexity and trade what are the implications on trading activity if investors are not sophisticated enough to understand and evaluate trades that have a complex payoff structure can frictions generated by this type of financial complexity be so severe that they lead to a complete market freeze like that of the recent financial crisis starting from an allocation that is not pareto optimal we find that whether complexity impedes trade depends on how investors perceive risk and uncertainty for smooth convex preferences such as subjective expected utility complexity cannot halt trade even in the extreme case where each investor is so unsophisticated that he can only trade up to one arrow debreu security without being able to combine two or more in order to construct a complex trade however for non smooth preferences which allow for kinked indifference curves such as maxmin expected utility complexity can completely shut down trade

unemployed but optimistic optimal insurance design with biased beliefs biased perceptions of risks change the perceived value of insurance and the per ceived returns to avoiding these risks i show empirically that unemployed workers overestimate how quickly they will nd work but underestimate the return to their search eorts i analyze the consequences for the optimal design of unemployment insurance with biased beliefs contracts equalizing the marginal smoothing ben e t and the moral hazard cost of insurance are suboptimal social and private insurance diverge a paternalistic social planner corrects the moral hazard cost for the distortion in the insured s eort choice while private insurers focus on the perceived rather than the true smoothing bene ts when unemployed workers are optimistic privatizing unemployment insurance may result in ine ciently low or rapidly decreasing unemployment bene ts

synthetic or real the equilibrium effects of credit default swaps on bond markets we provide a model of nonredundant credit default swaps cdss building on the observation that cdss have lower trading costs than bonds cds introduction involves a trade off it crowds out existing demand for the bond but improves the bond allocation by allowing long term investors to become levered basis traders and absorb more of the bond supply we characterize conditions under which cds introduction raises bond prices the model predicts a negative cds bond basis as well as turnover and price impact patterns that are consistent with empirical evidence we also show that a ban on naked cdss can raise borrowing costs

socioeconomic status and macroeconomic expectations we show that individuals macroeconomic expectations are influenced by their socioeconomic status ses people with higher income or higher education are more optimistic about future macroeconomic developments including business conditions the national unemployment rate and stock market returns the spread in beliefs between high and low ses individuals diminishes significantly during recessions a comparison with professional forecasters and historical data reveals that the beliefs wedge reflects excessive pessimism on the part of low ses individuals ses driven expectations help explain why higher ses individuals are more inclined to invest in the stock market and more likely to consider purchasing homes durable goods or cars received november 13 2017 editorial decision february 12 2019 by editor wei jiang authors have furnished an internet appendix which is available on the oxford university press web site next to the link to the final published paper online

a theory of subjective compound lotteries abstract we develop a savage type model of choice under uncertainty in which agents identify uncertain prospects with subjective compound lotteries our theory permits issue preference that is agents may not be indifferent among gambles that yield the same probability distribution if they depend on different issues hence we establish subjective foundations for the anscombe aumann framework and other models with two different types of probabilities we define second order risk as risk that resolves in the first stage of the compound lottery and show that uncertainty aversion implies aversion to second order risk which implies issue preference and behavior consistent with the ellsberg paradox

explaining credit default swap spreads by means of realized jumps and volatilities in the energy market abstract this paper studies the relationship between credit default swap cds spreads for the energy sector and oil futures dynamics using data on light sweet crude oil futures from 2004 to 2013 which contains a crisis period we examine the importance of volatility and jumps extracted from the futures in explaining cds spread changes the analysis is performed at an index level and by rating group as well as for the pre crisis crisis and post crisis periods our findings are consistent with merton s theoretical framework at an index level futures jumps are important when explaining cds spread changes with negative jumps having higher impact during the crisis the continuous volatility part is significant and positive indicating that futures volatility conveys relevant information for the cds market as for the analysis per rating group negative jumps have an increasing importance as the credit rating deteriorates and during the crisis period while the results for positive jumps and futures volatility are mixed overall the relation between the cds market and the futures market is stronger during volatile periods and strengthened after the global financial crisis

pricing credit default swaps with option implied volatility using the industry benchmark creditgrades model to analyze credit default swap cds spreads across a large number of companies during the 2007 09 credit crisis the authors demonstrate that the performance of the model can be significantly improved by calibrating it with option implied volatility rather than with historical volatility moreover the advantage of using option implied volatility is greater among companies with more volatile cds spreads more actively traded options and lower credit ratings

differences of opinion endogenous liquidity and asset prices this paper studies how investors differences of opinion affect liquidity and asset prices in our economy excessively optimistic investors are subject to an endogenous funding constraint that prevents default due to ex ante limited commitment when the funding constraint binds optimists use their savings to increase their consumption share deterring default this allows them to place speculative trades increasing market liquidity their losses on these trades make them prone to default leading to a renewed binding of the funding constraint this feedback between funding illiquidity disagreement and market liquidity is consistent with several empirical features of liquidity and financial asset prices

the social cost of near rational investment abstract we show that the stock market may fail to aggregate information even if it appears to be efficient and that the resulting decrease in the information content of prices may drastically red

thar she blows can bubbles be rekindled with experienced subjects we report 28 new experiment sessions consisting of up to three experience levels to examine the robustness of learning and error elimination among participants in a laboratory asset market and its effect on price bubbles our answer to the title question is yes we impose a large increase in liquidity and dividend uncertainty to shock the environment of experienced subjects who have converged to equilibrium and this treatment rekindles a bubble however in replications of that same challenging environment across three experience levels we discover that the environment yields a rare residual tendency to bubble even in the third experience session therefore a caveat must be placed on the effect of twice experienced subjects in asset markets in order for price bubbles to be extinguished the environment in which the participants engage in exchange must be stationary and bounded by a range of parameters experience including possible error elimination is not robust to major new environment changes in determining the characteristics of a price bubble jel c91 d83

on the equality of two lower bounds on the call price a note this note shows that appearances to the contrary the lower bounds on the price of a call option obtained by levy and by ritchken are identical and that this common bound is never inferior to the lower bound obtained by perrakis and ryan