80th Seminar on Finance and Accounting

Topic: Beauty Contests, Heterogeneous Beliefs, and Bubbles in Stocks and Options

 

 PresenterH. Henry Cao, professor, Cheung Kong Graduate School of Business

Time: October 24, 2008(Friday)300430 PM    

 

Venue:  Room 501, Jiageng Bld 2

 

Chair: Zhe Shen, assistant professor in finance, IFAS

 

 

Abstract:

 

We analyze how beauty contests due to dynamic trading in the presence of heterogeneous

beliefs on public information can result in bubbles in stocks and options. We show that

the effects of additional trading sessions on the stock price can be decomposed into two

effects, the expectation effect and the risk premium effect. The ¯rst effect is caused by

the differences about the mean of the public information among investors. When investors

optimistic (pessimistic) about the public information have higher precision, the stock price

will be higher (lower). The second effect is due to the disagreement about the covariance of

the public information and the stock, which results in a reduction of risk premium, due to

mutual insurance among investors provided by dynamic trading. The risk reduction effect

causes the stock price to increase with the number trading sessions when investors agree

on the expectation of the public signals. Dynamic trading also have two effects on options

prices. The ¯rst effect is that the implied volatility in stock option prices will always decrease,

which reduces option prices. The second effect is that as the stock price will change, this

will in turn affect options prices. Hence, option prices can be higher or lower depending on

the trade off between the two effects. Due to the reduction of risk, dynamic trading results

in higher market liquidity. In the special case that investors disagree about the mean of

the public information but agree on the covariance between the public signals and the stock

payoff, the stock and option prices are not affected. We extend our results to heterogeneous

priors on stock payoffs, dynamic trading without options and multiple stocks.