Working Paper: CEPR ID: DP7506
Authors: Giovanni Cespa; Xavier Vives
Abstract: We investigate the dynamics of prices, information and expectations in a competitive, noisy, dynamic asset pricing equilibrium model. We show that prices are farther away from (closer to) fundamentals compared with average expectations if and only if traders over- (under-) rely on public information with respect to optimal statistical weights. Both phenomena, in turn, occur whenever traders speculate on short-run price movements. For a given, positive level of residual payoff uncertainty, over-reliance on public information obtains if noise trade displays low persistence. This defines a "Keynesian" region; the complementary region is "Hayekian" in that prices are systematically closer to fundamentals than average expectations. The standard case of no residual uncertainty and noise trading following a random walk is on the frontier of the two regions and identifies the set of deep parameters for which traders abide by Keynes' dictum of concentrating on an asset "long term prospects and those only." The analysis explains accommodation and trend chasing strategies as well as momentum and reversal.
Keywords: average expectations; efficient market hypothesis; higher order beliefs; long and short-term trading; momentum; opaqueness; overreliance on public information; reversal
JEL Codes: G10; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| over-reliance on public information (D83) | prices farther away from fundamentals (G19) |
| low persistence of noise trading (G14) | over-reliance on public information (D83) |
| under-reliance on public information (D83) | prices closer to fundamentals (D41) |
| residual uncertainty and persistence of noise trading (D89) | over- or under-reliance on public information (D83) |
| speculation on short-term price movements (D84) | prices deviate from average expectations of fundamentals (E30) |
| trading strategies (accommodation, trend chasing) (G11) | momentum and reversal phenomena in asset prices (E32) |