Topic: Beauty Contests, Heterogeneous Beliefs, and Bubbles in Stocks and
Options
Presenter:H. Henry Cao, professor, Cheung Kong Graduate School of Business |
Time: October 24, 2008(Friday)3:00—4:30 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.