Research proposal Mispricing and heterogeneous agents in financial markets: a coordination problem

Evidence in financial markets, about aggregate stock market and cross-section of average returns, and individual trading behaviours seem to be not easily understood in the traditional finance paradigm. A more accurate description of financial markets is thus needed to account for such evidence. First, financial markets may exhibit in some occasions mispricing – asset prices differ from their fundamental values. Even if assessing fundamental values of financial assets is a tricky matter, some features of asset prices are most plausibly interpreted as deviations from fundamental values, which persisted over time. Persistent mispricing will result in the predictability of asset returns, from which some investors can take advantage and systematically make profits. But this would invalidate the predictions of traditional finance which suggest that no investor can systematically beat the market and earn expected profits in excess of equilibrium levels. Hence evidence of mispricing in financial markets, for which no rational explanations exist, cannot be fully explained by traditional finance founded on the Efficient Market Hypothesis (EMH) which assumes that “prices are right” – asset prices reflect its fundamental value 1. However since financial markets are concerned with allocating capital to the most promising investment opportunities, “prices are right” becomes a central issue. Second, agents that participate in financial markets – investors – are heterogeneous – institutional versus individual investors, differences in endowments, in trading strategies or with respect to information – and may exhibit less-than-perfectly rational behaviours. Thus in such context, dealing with a representative agent, assumed fully rational2, may not be reasonable. One may then ask how to account for behavioural complexities? How the latter may affect investors and their trading? But also how the interactions between heterogeneous agents may influence asset prices? In such context, I believe that one way to go is to inspect whether mispricing phenomena – including bubbles as an extreme case – are due to a coordination problem between heterogeneous agents. For that a better understanding of agents’ behaviour is needed, in order to investigate how investors interact in the market and what may be the outcome of their interactions. From this point of view, I believe that results in behavioural finance may be enlightening. In a preliminary work, I investigated first some features of asset prices considered as anomalies by traditional finance in order to consider why alternative explanations are needed. Actually if one believes in efficient markets, one would believe that market prices provide the information that investors need to trade in an optimal way. But then one may ask whether this assumption is reasonable, whether investors are actually able to read properly market prices and use market information. The examination of some financial anomalies – such as changes to the S&P 500 Index, international investing and home bias, pricing of closed-end funds – provides some elements to believe that this may not be the case. Indeed first, all investors may not have the expertise and the knowledge to identify and trade some mispricings. Second, not only new information but also investors’ sentiment seems to influence asset prices. Furthermore one who believes in efficient markets will disregard the current market, since broad diversification is the ideal goal to be achieved. But such belief may lead investors to make considerable mistakes when they trade because it prevents them to account for the trading activity of the others. Whenever rational explanations fail to account for financial anomalies, alternative explanations in terms of investors’ expectations and investors’ awareness may be noteworthy to
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Fundamental value is generally assumed to be the discounted sum of expected future cash flows. Rationality implies two ideas. First, when they receive new information, agents update their beliefs correctly, in the manner described by Bayes law. Second, given their preferences, agents make choices that are normatively acceptable, i.e. consistent with Savage’s notion of Subjective Expected Utility (SEU).

limits of arbitrage and investors’ psychology . and the rest of the population that has to learn the fundamental value from public information such as prices. Indeed behavioural economists turn to the extensive experimental evidence compiled by cognitive psychologists on the biases that arise when agents form their beliefs. Actually while traditional finance seeks to understand asset pricing through models in which agents are rational and exhibit consistent beliefs3. In the first case. First agents may be subject to judgmental biases that prevent them to form correct beliefs and to use properly the available information. human patterns of less-than-rational behaviours may be noteworthy to explain financial market behaviour. less-than-perfectly rational behaviours can have a substantial and long-lived influence on prices. The idea that behavioural finance is built on two pillars . behave. However the analysis sheds light on a more crucial source of heterogeneity based on information. providing a more realistic analysis of agents behaviours and asset originally due to Shleifer and Summers (1990). investors’ demand for financial assets may be influenced by their beliefs or sentiments. helps understand how agents. and on agents’ preferences. The second assumption 3 Consistent beliefs express the fact that agents’ beliefs are correct. how they interact in the market and what is the outcome of their interaction. Facing these results. This is instructive when one wants to account for the influence of investors’ sentiment on asset prices.understand asset pricing. Moreover agents may make choices that are not normatively acceptable and may not be able to achieve their goals in the best way. While there is no evidence supporting clear irrationality among investors. there is asymmetric information between a group of agents that observe a private signal. since they provide elements to understand how agents use and interpret information – useful to define accurately agents heterogeneity – and how agents make their decisions. not fully rational. In asset pricing models. Thus behavioural finance. and institutional differences6 between investors on financial markets. use market information and trade is then a central issue. (1990). and why in financial markets. 4 . this feature may arise because of two assumptions: differential information and differential interpretation. I believe that this is a necessary first step to understand how investors choose their portfolios and how they trade. behavioural finance proposes some crucial elements to understand how agents may deviate from rationality and proposes to explain some financial anomalies through models in which agents are no more fully rational. Contrary to traditional finance. Thus looking more closely at investors’ behaviour may be enlightening to understand market behaviour and some of these anomalies. Asymmetric information causes heterogeneous expectations among agents which play a significant role in asset pricing. This literature widely documents human patterns of less-than-rational behaviours. How heterogeneous market participants make their decisions. I believe that the results in behavioural finance have to be considered in order to propose an alternative explanation of mispricing phenomena in financial markets based on a coordination problem between heterogeneous agents. which may lead them to trade not only based on market information. 6 Institutional versus individual investors. Consequently I considered also some works in behavioural finance since this approach proposes a more accurate explanation of agents’ behaviour. These considerations on agents’ rationality are instructive to understand asset pricing. This investigation gives support to our prior intuition about the relevance of agents’ heterogeneity in explaining financial anomalies. market forces which bring back asset prices toward fundamental values may be limited 5. Behavioural finance rests on a second building block4: limits of arbitrage. and about the diversity in the sources of heterogeneity – differences in preferences. it may be tricky to sustain that agents are able to read and use perfectly market information. Actually heterogeneity of agents is widely accepted in economics and finance literature as the explanation for trade and is increasingly integrated as a key feature of asset pricing models. Wurgler and Zhuravskaya (2002). differences in endowments. Shleifer and Vishny (1997). 5 DeLong et al. In a market where rational investors interact. Finally I examined some works in which models based on heterogeneous agents are used in order to explain some mispricings.

. While rational arbitrageurs have to coordinate their actions in order to trade effectively the mispricing. arbitrage is delayed and the mispricing may persist in the market even if some rational arbitrageurs are aware about it and may trade it efficiently. since they become sequentially aware about changes in the fundamental value of the risky asset. Consequently. where rational arbitrageurs interact with behavioural agents – boundedly rational – arbitrage is limited because the former face uncertainty about when other rational arbitrageurs will start exploiting a common arbitrage opportunity. Recent empirical evidence suggests that the use of internet to trade is more and more widespread among investors and that this new “style investing” promotes overconfidence.. Thus one psychological bias that may be further explored and worthwhile incorporating in such model could be overconfidence. Furthermore the increasing use of internet changes significantly how information is delivered to investors and the ways in which investors can act on that information. These elements give support to our prior intuition about the fact that it could be controversial to assume that agents are able to read perfectly market prices. capital constraints and imperfect substitutes – do not help explain mispricing. rational arbitrageurs would not only have to account for the behaviour of other rational agents but also have to account for the decisions of behavioural agents. 8 First proposed by Abreu and Brunnermeier (2002). I believe that the assumption that agents interpret public information identically is too restrictive. In such framework. Relaxing this assumption would change significantly the analysis and may help provide more accurate explanations for financial anomalies. In such framework. Journal of Political Economy 103 :4. some issues remain unsolved and would be the object of future research. I believe that a framework based on synchronisation risk8 offers a more accurate and promising way to propose an alternative explanation based on a coordination problem between heterogeneous agents. investors seem to trade more actively and more speculatively. Furthermore as suggested by Kandel and Pearson (1995)7. One would then provide a more accurate analysis of the interactions between heterogeneous agents. 1995. N. When standard market imperfections – such as cost of information and trade. 7 Kandel. While my previous work has been instructive for clarifying several issues – theoretical approach to be adopted. 831-872. While this analysis focuses mainly on the decision-making of rational arbitrageurs. Differential interpretation of public signals and trade in speculative markets. when some decide to trade the mispricing. A coordination problem arises among rational arbitrageurs. Synchronization risk stems from the uncertainty about the market timing decision of other rational arbitrageurs. After going online. E. . and Pearson. not only based on differential information but also on differential interpretation. it would be worthwhile focusing also on the decision-making of behavioural agents. as one way to relax the assumption that agents interpret identically market based on the fact that public information can be interpreted in different ways by agents. relevant features of agents’ heterogeneity and significance for the analysis of financial anomalies – and convincing enough to believe that mispricing phenomena may be better understood by focusing on the interactions between heterogeneous agents. they face uncertainty about when the other rational arbitrageurs will also trade it. Agents use different “models of the market” to update their subjective valuation. which might lead them to hold different beliefs. Modelling explicitly the behavioural agents’ decision-making would be based on welldocumented and relevant judgmental biases.