Art Forgery, Artist Death and Collectors' Wealth under

Speculation: Art as an Alternative Investment

Alejandro Bernales, Lorenzo Reus and Víctor Valdenegro*

This version: April 2nd, 2020.

Abstract

We examine the unexplored effects on art markets of artist death, collectors' wealth and forgery,
under short-sale constraints and risk-aversion. Speculative bubbles increase with: constraints on
the art supply due to artists’ deaths; more negative correlation between collectors' wealth and
the artworks' emotional value; a more positive association between forgery and the artworks'
emotional value; and more heterogeneous beliefs. These four sources of speculation increase the
expected turnover-rate; however, they also augment the variance of speculative bubbles, which
generates larger price discounts (i.e. risk premiums) for holding artworks. Consequently, the net
impact of speculation is not necessarily increased art prices.

JEL Codes: D84; G11; G12; Z11

Keywords: Art Markets, Speculative Bubbles, Art Forgery, Background Risk, Limited Supply,
Risk Aversion.

* Alejandro Bernales, corresponding author, is at Universidad de Chile (Facultad de Economía y Negocios,

Departamento de Administración), email: abernales@fen.uchile.cl. Lorenzo Reus is at Universidad Adolfo
Ibáñez, email: lorenzo.reus@uai.cl. Víctor Valdenegro is at Universidad de Chile (Center of Applied
Economics and Center of Finance, DII), email: vvaldenergro@dii.uchile.cl. We are grateful to participants in
seminars and meetings at the Developments in Alternative Finance Conference (Birmingham Business
School), Banque de France, Universidad Adolfo Ibáñez and Universidad de Chile. We are grateful to William
L Megginson (the Editor) and one anonymous referee for their constructive comments. We would also like
to thank Andrea Acuña, Xiaohua Chen, Piotr Danisewicz, Hervé Roche, Christophe Spaenjers, Marcela
Valenzuela and Patricio Valenzuela for their invaluable comments. Alejandro Bernales acknowledges
financial support from ENLACE project #ENL13/18, the Institute for Research in Market Imperfections and
Public Policy (ICM IS130002, Ministerio de Economía de Chile) and FONDECYT project #1190162. Lorenzo
Reus acknowledges financial support from FONDECYT #11170012. The views expressed in this paper do
not necessarily reflect the opinion of the authors' institutions. Any errors made are our own.
0
Art Forgery, Artist Death and Collectors' Wealth under
Speculation: Art as an Alternative Investment

This version: April 2nd, 2020.

Abstract

We examine the unexplored effects on art markets of artist death, collectors' wealth and forgery,
under short-sale constraints and risk-aversion. Speculative bubbles increase with: constraints on
the art supply due to artists’ deaths; more negative correlation between collectors' wealth and
the artworks' emotional value; a more positive association between forgery and the artworks'
emotional value; and more heterogeneous beliefs. These four sources of speculation increase the
expected turnover-rate; however, they also augment the variance of speculative bubbles, which
generates larger price discounts (i.e. risk premiums) for holding artworks. Consequently, the net
impact of speculation is not necessarily increased art prices.

JEL Codes: D84; G11; G12; Z11

Keywords: Art Markets, Speculative Bubbles, Art Forgery, Background Risk, Limited Supply,
Risk Aversion.

0
1 Introduction

Nowadays, the market for artworks is an important sector of the economy. For instance, UBS and

Art Basel recently reported that there are 310,685 businesses related to the art market, comprising

296,540 in the gallery sector and 14,145 auction houses, which directly employed an estimated

3,000,000 people as of 2017. In addition, artworks are important alternative assets, since they are

currently used as collateral for obtaining external funding. For example, in the US alone, Deloitte

reported that the art-secured lending market reached an estimated $17-20 billion in 2016, with a

13.3% growth from 2015. Moreover, artworks are important alternative assets used as a store of

value, similarly to gold or other commodities. For instance, UBS and Art Basel show that the global

art market reached $63.7 billion, and that 35% of high-net-worth individuals were active in the art

and collectibles market, in 2017.

Simultaneously, a growing theoretical literature has improved our understanding of

potential determinants of art market dynamics, which are different from the factors that describe

other financial markets. A particular feature of art markets, which has been characterized in

previous theoretical studies, is that artworks are at once durable 'emotional' consumption goods

and financial assets. On the one hand, the value of an art piece has a component related to an

expected 'emotional' (non-financial) consumption value, associated with diverse feelings generated

by the ownership of artworks.1 On the other hand, the value of an artistic object has a component

related to an expected resale (financial) value, due to the potential revenues that can be made when

artworks are resold in the future (see, e.g., Lovo and Spaenjers, 2018). Moreover, we know that the

expected resale value may increase due to speculation, given that short sales are limited in the art

market, and agents are heterogeneous in their beliefs about the 'emotional' value of artworks. Thus,

we can observe speculative bubbles in the art market, since agents anticipate a future 'optimism'

1
Some of the feelings that an artwork can generate are the experience of enjoying artistic objects, an
ownership effect related to the pride one feels in having art pieces, and a luxury 'appetite' for signaling social
status and/or conspicuous consumption, amongst other emotions (see Frey and Eichenberger, 1995; Aït-
Sahalia et al., 2004; and Mandel, 2009).
1
effect, through which there is a possibility of finding future buyers of resold artworks who will pay

even higher prices due to belief disagreement (see Penasse and Renneboog, 2018).

In this article, we contribute to the literature by analyzing the effect on the art market of

three new elements that are important components of it, through a model where agents trade

artworks, and which includes the determinants of the art market described above. These three

additional components that we examine are (i) the effect on art prices of supply constraints on

artworks due to artist deaths; (ii) the impact on the art market of the relationship between

collectors' wealth and the 'emotional' value of artworks; and (iii) the effect on the art market of

forgery.

Firstly, we study the effect of art supply constraints on the art market because, differently

from that of manufactured products, the supply of artworks can no longer react to changes in art

prices after the artist has died. This means that the elasticity of supply is zero after the artist’s death

(see Baumol, 1986; and Mandel, 2009). This analysis is crucial to understanding the art market,

since there is empirical evidence showing that a limited art supply is an important driver of art

prices. For instance, Spaenjers et al. (2015) show that auction records may be set in situations

characterized by extreme supply constraints, while Renneboog and Spaenjers (2013) find a positive

effect on art prices of the death of the artist.2

Secondly, we want to study the impact of the relation between art collectors' wealth and the

'emotional' value of artworks. In fact, there is evidence of a relationship between art prices and the

wealth of art collectors. For instance, Mei and Moses (2002) use a one-factor asset pricing model on

art returns and show evidence, similarly to Goetzmann’s (1993), that the stock market drives the

art market because the demand for artworks increases with the wealth of art collectors. In addition,

Goetzmann et al. (2011), Renneboog and Spaenjers (2013), Korteweg et al. (2015) and Penasse and

2
Our study is not focused on artworks generated by artificial intelligence (which are not affected by art
supply constraints). Instead, our paper focuses on original art pieces produced by artists who are human
beings; thus, there are art supply constraints on original artworks after the artist’s death.
2
Renneboog (2018) find that art prices are strongly associated with the wealth of high-income

individuals, who are the potential collectors of artworks.

Thirdly, we study the impact of forgery on art markets. Art forgery is important since

individuals may buy art pieces, and later on realize that they are not authentic. Thus, art buyers are

exposed to a reduction of their 'emotional' payoff, if the art pieces they buy turn out not to be

originals. This is because some of the 'emotional' payoff is related to the pride of owning unique art

pieces from recognized artists and a luxury 'appetite' for signaling social status and/or a refined

taste. In economics, there are studies of the negative impact of counterfeiting on trademarks (e.g.,

Grossman and Shapiro, 1988a,b) and the negative economic effect of property rights infringements

(e.g. Feinberg and Rousslang, 1990). However, the effect of forgery on the art market has not been

studied from a theoretical point of view, combined with art supply constraints and wealthy

collectors under speculation.

Furthermore, we want to study the effect on the art market of these three drivers (i.e. art

supply constraints due to artist death, the relationship between collectors' wealth and the

'emotional' value of artworks, and art forgery) when risk aversion is considered. This is because (as

explained above) we can observe speculative bubbles in the art market given that there are short-

sale constraints and heterogeneous beliefs. However, potential sources of such speculation can also

increase the art price volatility. Thus, risk-averse agents may require a larger price discount (i.e. a

risk premium) when there is speculation in this market.

Despite the common use of risk-neutral preferences to make models tractable in theoretical

studies of the art market, it is recognized by previous literature that considering risk-averse agents

is fundamental to understanding art price dynamics. For instance, Pownall (2014) argues that

agents take decisions to participate in the art market by considering the trade-off between risks

and potential benefits in terms of the 'emotional' and resale values provided by holding artworks.

Moreover, the assumption of risk neutrality makes addressing how the art price variance affects the

3
prices of artworks difficult. For example, Lovo and Spaenjers (2018) write, in relation to the risk-

neutral assumption of their model, "Something that we may miss by taking this shortcut are the

effects that utility flow volatility and uncertainty over future resale revenues would have on owners’

decision-making if they are risk-averse".

To analyze these unexplored elements that are part of the art market, we consider a model

with risk-averse agents, who trade and enjoy artworks under short-sale constraints. There is a

limited supply of artworks, and their owners benefit from a stochastic 'emotional' dividend.

However, artistic objects are exposed to forgery, which reduces the net 'emotional' payoff of

artworks. The harmful impact of art forgery is positively correlated with the 'emotional' dividend;

this reflects the fact that, when art pieces have a large 'emotional' dividend (which increases the

price of artworks), there is more chance of observing art forgery.

There are two types of agents: art lovers (i.e. collectors) and speculators. Art lovers are

wealthy and their wealth is correlated with the 'emotional' dividend, while speculators are born

without any endowment. Art lovers and speculators are heterogeneous in their beliefs about the

expected value of the 'emotional' dividend, and the magnitude of the disagreement is stochastic. In

addition, art lovers are biased since they expect to gain additional 'emotional' benefits from the

ownership of artworks, because they really love art.3 Moreover, we include the existence of

potential costs associated with insurance, restoration, security (avoidance of theft), waiting and/or

potential transaction costs related to artworks.

The model generates implications that have not been observed in previous theoretical

studies related to art markets. We find that speculation does not necessarily increase the price of

artworks if agents are risk-averse. For instance, on the one hand, when there is an increase in the

magnitude of the stochastic disagreement about the expected value of the ‘emotional’ dividend, we

3Goetzmann and Spiegel (1995) argue that art lovers (collectors) are willing to overpay for artworks; this is
because they can forego some of the financial benefits in exchange for the additional 'emotional' value they
gain.
4
show that agents anticipate there will be more chance of finding buyers to whom they might resell

artworks, and who will pay higher prices for them (i.e. it is more likely that a future 'optimism'

effect will be observed). This speculative behavior, in which the value of the resale option increases,

induces speculative bubbles, since agents pay prices today that are higher than their own

expectations about the future value of the artworks.

On the other hand, a greater stochastic magnitude of the disagreement also increases the

variance in the future prices of artworks. The intuition behind this result is simple. Supposing there

is no disagreement about the future value of the ‘emotional’ dividend, then both agent types (i.e. art

lovers and speculators) will always participate in the art market. In this case, the volatility of the

future artwork price is zero, because it does not depend on the stochastic level of the disagreement.

In contrast, suppose there is disagreement between agent types, and this disagreement is large

enough to observe the 'optimism' effect, where the agent type with the higher future valuation will

buy all the artworks. In this second case, the future artwork prices will be volatile. This is because

future artwork prices will be given by the valuation of the optimistic agent type, which will be

random since they depend on the 'stochastic' magnitude of the disagreement. Thus, if agents are

risk-averse, they will require a larger price discount ‒a risk premium‒ for holding artworks if the

magnitude of the stochastic disagreement goes up.

Consequently, depending on the market conditions, sometimes the bubble effect (from the

agents' speculative behavior) will be stronger than the effect of the increase in risk premium (from

the rise in the variance in the future prices of artworks) when the magnitude of the stochastic

disagreement increases, while at other times we will observe the opposite net effect. This model

implication can explain the risk premium observed in the art market, which is lower than the equity

risk premium, despite that the art market has a higher level of volatility than the equity market. For

instance, Renneboog and Spaenjers (2013) report that, in the period 1957-2007, the art market had

a real excess return of 2.58% with a standard deviation of 19.05% in the real returns; meanwhile, in

5
the same period, the US equity market and worldwide equities had real excess returns of 5.24% and

4.95% with standard deviations of 16.54% and 16.16% in the real returns, respectively.

We also show that a potential future 'optimism' effect has the form of an option strangle

strategy. This option strangle is formed by a put option and a call option with the underlying asset

being the stochastic component of the difference in beliefs. We show that the call and put options

are more in-the-money when the supply of artworks decreases (which means there is more chance

of observing an 'optimism' effect); thus, the size of the bubble generated by the resale option goes

up. This finding is consistent with Renneboog and Spaenjers (2013), who show a positive impact on

art prices of artist deaths (which generate supply constraints), in a sample between 1957 and 2007

that includes 10,442 artists and 1,088,709 artwork sales. However, the variance of future prices

also increases, because the probability of observing an 'optimism' effect goes up when the supply of

artworks is lower due to artist deaths. This also augments the price discount for holding artworks.

Thus, it is also the case that a decrease in the fixed supply of artworks does not necessarily augment

their price if agents are risk-averse. This model implication can explain the mixed empirical results

observed in the art market when similar artworks are sold. For instance, there is evidence that the

prices of identical objects are more likely to decline than increase when multiple similar units are

sold (see, e.g., Pesando and Shum, 1996; and Beggs and Graddy, 1997). However, Spaenjers et al.

(2015) show that auction records are also observed when multiple versions or editions of an

artwork exist.

If agents are risk-neutral, the art market is not affected by the correlation between the art

collectors' wealth and the 'emotional' dividend. However, if agents are risk-averse, we find that an

increase in that correlation reduces the diversification features of collectors under short-sale

constraints, which is reflected in a reduction in their valuation of artworks. This also decreases the

possibility of observing an 'optimism' effect among collectors (i.e. where they buy everything in the

art market), which shrinks the price of artworks since the value of the resale option goes down.

6
This is consistent with the empirical evidence of a strong relationship between art prices and the

wealth of high-income individuals (see, e.g., Hiraki et al., 2009; Goetzmann et al., 2011; Renneboog

and Spaenjers, 2013; and Penasse and Renneboog, 2018). Nevertheless, we show that the variance

of the resale value also decreases when the aforementioned correlation goes up, which augments

the price of artworks, since the risk premium required by agents in return for holding artworks

diminishes. Thus, the price of artworks does not necessarily decrease with the correlation between

art collectors' wealth and the 'emotional' dividend.

Unsurprisingly, an increase in the expected harmful impact of forgery induces a reduction in

art prices. However, an interesting result emerges when there is a rise in the positive correlation

between the damaging impact of art forgery and the ‘emotional’ dividend.4 In the case of a rise in

this correlation, if the ‘emotional’ dividend increases (which generates a rise in the ‘emotional’

value of art pieces), then there is more chance of art forgery (which moves back the ‘emotional’

value of artworks).5 Hence, an increase in the positive correlation between art forgery and the

‘emotional’ dividend causes a reduction in the volatility of the net ‘emotional’ payoff (i.e. the net

‘emotional’ payoff is more stable). Most importantly, there is a reduction in the price discount due to

the decline in the volatility of the net ‘emotional’ payoff (i.e. the risk premium decreases), when

there is a rise in this correlation. This reduction in the risk premium increases the chances of

observing an 'optimism' effect in both agent types (i.e. collectors and speculators).

Consequently, when there is a rise in the positive correlation between art forgery and the

‘emotional’ dividend, the value of the resale option goes up, and so does the price of artworks. This

is due to the fact that there is more chance of an 'optimism' effect when this correlation rises (as

explained in the previous paragraph). Nevertheless, the volatility of the value of the resale option

also increases when there is a rise in this correlation. This is because there is more chance of

4 As with the correlation between the art collectors' wealth and the 'emotional' dividend, if agents are risk-
neutral, the art market is not affected by the correlation between the harmful impact of art forgery and the
‘emotional’ dividend.
5 In the same way, and also when such correlation rises but the ‘emotional’ dividend decreases, there is a

lower probability of observing a harmful impact of forgery on the art market.

7
observing an optimistic agent type, who will buy all the artworks, whose valuation will be random

since it depends on the stochastic magnitude of the disagreement, which makes the value of the

resale option more volatile. Thus, the risk premium associated with volatility of the value of the

resale option grows, which also reduces the art price, when there is an increase in the positive

correlation between art forgery and the ‘emotional’ dividend.

Therefore, in summary, a rise in the positive correlation between art forgery and the

‘emotional’ dividend generates: i) a reduction in the volatility of the net ‘emotional’ payoff (which

increases the chances of observing an ‘optimism’ effect); ii) a growth in the value of the resale

option (which increases the price of artworks); and iii) an increase in the volatility of the resale

option (which reduces the price of artworks). Consequently, a rise in this correlation does not

necessarily increase (or reduce) the prices of art pieces.

We also find that the expected turnover rate goes up when there are reductions in the

supply of artworks due to artist deaths; there is more negative correlation between collectors'

wealth and the 'emotional' value of artworks; there is a more positive correlation between forgery

and the 'emotional' value of artworks; and there is an increase in the heterogeneity of beliefs. This

is in line with the empirical results of Penasse and Renneboog (2018) and Penasse, Renneboog and

Scheinkman (2019), who show that bubbles in the art market are related to increases in the trading

activity and price dispersion, which is also observed in other markets (see, Xiong, 2013, for a

review of bubble episodes in diverse financial markets).

The variance of price changes increases with reductions in the art supply due to artist

deaths; a more negative correlation between collectors' wealth and the 'emotional' value of

artworks; and rises in the heterogeneity of beliefs. Nevertheless, the variance of price changes does

not necessarily go up when there is a more positive correlation between forgery and the 'emotional'

value of artworks. This is because, as previously explained, an increase in the correlation between

8
the harmful impact of art forgery and the ‘emotional’ dividend simultaneously reduces the volatility

of the net ‘emotional’ payoff and increases the volatility of the resale option.

Our paper is related to the increasing number of theoretical studies that analyze the

behavior of the art market. For instance, Lovo and Spaenjers (2018) present a dynamic auction

model with risk-neutral agents, who make trading decisions that depend on their intrinsic private

values. Penasse and Renneboog (2018) present a model of the art market with risk-neutral agents

under short-sale constraints, in which they show that belief disagreement always increases the

price of artworks. Mandel (2009) considers an asset pricing model with risk-averse agents,

although without short-sale constraints and heterogeneous beliefs, in which conspicuous motives

endogenously lower the average return on artistic objects.

Our paper is also connected to the literature on the effects of heterogeneous beliefs and

short-sale constraints on asset prices in 'traditional' financial markets (see, e.g., Miller, 1977; Chen

et al., 2002; and Hong and Stein, 2003). Our study is associated with studies that examine the

speculative component in asset prices. However, in these studies in general, risk neutrality is

assumed due to tractability issues (Harrison and Kreps, 1978; Morris, 1996; and Scheinkman and

Xiong, 2003). However, in the context of our study, in a model under risk neutrality, the

associations of the 'emotional' value of artworks with collectors' wealth and art forgery would have

no effect on art prices. In addition, in a model under risk neutrality, the impact on art prices of art

supply constraints due to artist deaths, which modify the art price volatility and thus the risk

premium, would not be fully captured.

Our paper is particularly related to Cao et al. (2007), Bai et al. (2006) and Cornelli and

Yilmaz (2015), who present rational expectations models under heterogeneous beliefs. They show

that short-sale constraints can increase price volatility, which induces a price reduction since risk-

averse agents require a risk premium to hold their riskier investments. However, they do not

analyze the impact of asset supply constraints or the effect of investors’ wealth on market

9
dynamics, as we do in our study.6 Consequently, our paper differs from the previous studies

described above since they do not simultaneously analyze the effect on the art market of art supply

constraints and the associations of the 'emotional' value of artworks with collectors' wealth and art

forgery, in the case of risk-averse agents (when there are also short-sale constraints, heterogeneous

beliefs, and additional 'emotional' benefits from owning artworks induced by a luxury 'appetite',

conspicuous consumption and/or social status).

The rest of the article is organized as follows. Section 2 introduces the basic environment.

Section 3 analyzes the effect of art supply constraints due to artist death, collectors' wealth and art

forgery on art markets. Section 4 concludes. The appendix contains omitted derivations and proofs.

2 Basic environment

We present a partial equilibrium model, in which there is an economy with three periods

( ). There are risk-averse agents, who exchange and enjoy artworks. There is a fixed

supply, , of artworks. The owners of artworks benefit from an 'emotional' dividend, , at .

The 'emotional' dividend is stochastic and reflects a non-pecuniary payoff. The 'emotional' dividend

is related to different feelings generated by artworks, such as the experience of enjoying artistic

objects, an ownership effect related to the pride felt in having art pieces, or a luxury 'appetite' for

signaling social status or conspicuous consumption, amongst other emotions (see, e.g., Frey and

Eichenberger, 1995; Aït-Sahalia et al., 2004; and Mandel, 2009).

Artistic objects are exposed to forgery, in the sense that owners of artworks may not own

authentic art pieces. Thus, the ‘emotional’ payoff of owning artworks can be reduced by a value, ,

at in the case of art forgery. This is because, as mentioned above, some of the ‘emotional’

dividends are related to the pleasure of being the owner of a unique artwork from a recognized

6Our study is also in line with Shleifer and Vishny (1997), who argue that risk aversion can be a potential
cause of the destabilizing of speculation, albeit they do not formalize this intuition in a model.

10
artist, or to a satisfaction with luxury in terms of being able to demonstrate one’s social status

and/or refined taste. Consequently, the total net value of the ‘emotional’ payoff (after the harmful

impact of forgery) is .

There are two types of agents: agents of type , art lovers (i.e. collectors); and agents of type

, speculators. Let be an agent indicator, where . Art lovers are wealthy, having been born

with an endowment of dollars that is a random variable and reflects their background risk;

speculators are born with zero dollars. Similarly to Simsek (2013a,b), we assume that the wealth of

agents of type is normally distributed with mean and variance (i.e. ).

At , both agent types have the same beliefs about the 'emotional' dividend, , and the

negative impact of art forgery, . Their beliefs at about are normally distributed with mean

and variance (i.e. ), while their beliefs about are also normally distributed, with

mean and variance (i.e. ), where is the correlation between E and .

Consequently, the agents’ beliefs about the total ‘emotional’ payoff, , are also normally

distributed, with mean and variance (i.e.

). In addition, the correlation between E and is , and the correlation

between and is .7 It is important to notice that the results obtained from the model do

not change qualitatively if we assume that agents have heterogeneous beliefs at .8 Therefore,

this assumption is used to simplify the intuitions behind the model, and thus to focus on the effect

of belief disagreements in one only period (i.e. at ), as we will explain in the following

paragraphs.

At time , each agent type independently receives some new information regarding a

potential change in the expected value of the 'emotional' dividend of the art pieces. These

information sets cause art lovers and speculators to have different beliefs about the expected value

of the total 'emotional' payoff provided by the artworks.

7
The findings obtained from the model do not change qualitatively if we assume that .
8 For instance, the outcomes of our model do not change if we assume that for speculators.
11
 ASSUMPTION 1: The beliefs of art lovers and speculators at are normally distributed,

denoted by and

, respectively. The value of is also normally distributed,

with mean zero and variance (i.e. ), and not correlated with ; and the

parameter reflects the additional benefit that art lovers receive from holding artworks.

Agents 'agree to disagree' in the sense that each agent knows the other agents' beliefs.

In Assumption 1, the random variable associated with the heterogeneous beliefs, , emerges

for several reasons, including different ways of analyzing and interpreting information,

overconfidence of agents regarding the quality of the signals they receive and/or other behavioral

biases. The nature of the additional benefit that art lovers receive at , which is reflected in , is

due to the additional pleasure they gain from the experience of enjoying artworks.9

Agents can trade the asset at and , and there are short-sale constraints. Similarly

to Harrison and Kreps (1978), Scheinkman and Xiong (2003) and Hong et al. (2006), we assume

that, in the economy, there is a discount rate . This means that agents can borrow and deposit at

the same interest rate, , or equivalently that agents discount all future payoffs using this rate r.

Thus, wealth does not constrain the consumption of artworks. There is also a quadratic cost of

holding the asset between periods. Thus, suppose that an agent of type at time has a quantity

of artworks, then the holding cost of this position is . This cost reflects insurance,

restoration, security (avoidance of theft), waiting and/or potential transaction costs related to

artworks. Therefore, the agents' net worth at time can be written as:

(1)

while the agents' worth at time are:

9Speculators do not receive the additional benefit, , since they do not 'love' art as art lovers (who are art
collectors) do. However, speculators also like artworks because they may still receive the 'emotional'
dividend at .
12
 (2)

Art lovers and speculators are identical in their preferences. Similarly to Hong et al. (2006),

Cao and Ou-Yang (2008), and Simsek (2013a,b), the agents’ utility function per period takes the

constant absolute risk aversion (CARA) form. Since all stochastic variables are normally distributed,

the agents' optimization reduces to the usual mean-variance problem (see Ingersoll, 1987; and

Eeckhoudt et al., 2005). Thus, each agent maximizes a per-period objective function:

(3)

where is the level of risk aversion. We assume this myopic objective function to avoid dynamic

strategies, which helps us to obtain a closed-form solution. Despite this objective function not being

ideal, the model outcomes would be unlikely to change qualitatively if dynamic strategies were

considered. Moreover, it is important to note that our focus is on providing a simple model that

reflects the price dynamics for artworks, where there are supply restrictions on art pieces due to

artist deaths, and an association of the 'emotional' value of artworks with collectors' wealth and art

forgery under a situation with risk-averse agents, while also considering short-sale constraints and

heterogeneous beliefs as in previous studies.

3 Understanding the effect of art supply constraints and collectors' wealth on art

markets

We use backward induction to solve for the holding equilibrium and prices at and

. Thus, we first solve for the equilibrium at . It is important to note that agents at

know what the differences in their beliefs are (i.e. at agents know and the realized value of

the stochastic variable ). Therefore, under the first-order condition of the objective function of

13
each agent, and using the fact that there is a fixed supply of artworks, we have three equations

and three unknown variables (i.e. and ):

(4)

(5)

(6)

Here, equations (4) and (5) represent the demand functions of art lovers and speculators,

respectively, which are downward sloping in the agents' holdings, while equation (6) describes the

relation between agents' holdings and the fixed supply of artworks.

The terms in the first set of parentheses in equations (4) and (5) show the highest price that

agents would pay to have a small portion of the artworks (i.e. when or ). The

maximum prices that art lovers and speculators would pay are

and , respectively. These maximum prices reflect the differences in valuations that

agents assign to artworks at . It is important to note that the differences in valuations are not

only related to heterogeneous beliefs (which are given by the terms and ), but also due to the

stochastic interaction between art lovers' wealth and the 'emotional' dividend, which is reflected in

ASSUMPTION 2: We impose , in order to have agents of type A who

are 'really' art lovers, in the sense that the expected maximum price they would pay is higher than

the expected maximum price speculators would pay.

We solve the equation system given by expressions (4)-(6) under short-sale constraints (i.e.

and ). The solution has three cases, which are described in Figure 1. The first case

is when we solve the equation system and obtain that and (i.e. the short-sale

14
constraints are not bounded for either agent), which is presented in the first branch of Figure 1. In

this case, the term in the first set of parentheses in the expression for (in the first branch of

Figure 1) is the average of the maximum prices that art lovers and speculators would pay for the

artworks (i.e. ). The term

reflects the price discount associated with the cost of

holding artworks, and the risk premium, which are shared between both agent types.

[Insert Figure 1 here]

The second and third cases are obtained when one of the agent types buys up the complete

supply of artworks, while the other sits out of the market (i.e. the second and third branches in

Figure 1). For instance, in the case that the art lovers’ valuation of artworks is much higher than the

speculators’ valuation (third branch in Figure 1), art lovers and speculators would ideally want to

have and . Since they cannot have these holdings, art lovers and speculators have

and . This case is observed when the minimum price that art lovers would pay for

artworks is larger than the maximum price that speculators would pay.10 In this case, is

determined by the minimum price that art lovers would pay for artworks. The intuition for the case

when the speculators’ valuation of artworks is much higher than the art lovers’ valuation is similar.

Consequently, the second and third branches of Figure 2 reflect an 'optimism' effect, which

appears when one agent type is much more optimistic than the other. Most importantly, the

'optimism' effect causes the price of the artwork at to be upward biased. This upward bias can

be observed mathematically in the following lemma:

LEMMA 1: The price of artworks at is composed of two components: a non-optimism effect,

, and an optimism effect, . Thus, can be expressed as:

10The minimum prices that art lovers and speculators would pay (i.e. when their holdings are equal to ) are
given by and
, respectively.
15
 (7)

where

(8)

(9)

with

(10)

Proof: Appendix.

Lemma 1 shows that the component of is the price of the first branch

in Figure 1, in which both agent types are long in the artworks. The component of

reflects the second and third branches of Figure 1. Equation (9) shows that the 'optimism' effect is

always positive, which reflects the upward bias of , as mentioned previously.

It is interesting to observe in Lemma 1 the effect of forgery on . On the one hand, the

expected harmful impact of forgery, , reduces (i.e. in equation (7)). On the other

hand, we know that the correlation between art forgery and the ‘emotional’ dividend is positive (i.e.

). Thus, when goes up, if the ‘emotional’ dividend increases (which generates an

increase in the ‘emotional’ value of art pieces at ), there will be more chance of art forgery and

hence also going up (which will cause the ‘emotional’ value of artworks to fall back down again).

Conversely, and also when such correlation increases but this time in the opposite direction, if the

‘emotional’ dividend decreases (which induces a reduction in the ‘emotional’ value of artistic

objects at ), then there will be less chance of art forgery and will also go down (which will

16
cause the ‘emotional’ value of artworks to move up again). Therefore, a rise in generates a

reduction in the volatility of the net ‘emotional’ value of artworks at (i.e.

), which means that the net ‘emotional’ payoff of art pieces is more stable at

. Most importantly, this reduction in the volatility of the net emotional payoff of artworks

reduces the price discount associated with the risk premium of holding artworks between

and .

We next solve for the holding equilibrium and price at . We have an equation system at

given by:

(11)

(12)

(13)

Equations (11) and (12) represent the demand functions at of art lovers and speculators,

respectively, which are also downward sloping. It is important to note that the correlation between

art lovers' wealth and the 'emotional' dividend does not appear in equation (11). This is because

agents at perceive that depends on only one random variable, (see Figure 1 and Lemma

1), which is not correlated with art lovers’ wealth.11

Despite the fact that art lovers and speculators agree to disagree at (as described in

Assumption 1), at both agent types have the same beliefs about the process of future

disagreement.12 Thus, in equations (11) and (12), and

11 The variable is only perceived by the agents as random at . At , is not stochastic since agents
know its realized value.
12 As described before, we assume that both agent types have the same beliefs at , in order to obtain a
closed-form solution, which helps us to explain the main intuitions of the model in a simple way. However, in
unreported analysis, we solve the equilibrium numerically for the case in which agents also disagree at .
These unreported results are consistent with the results reported in this paper.
17
 . Therefore, there is no 'optimism' effect on . The following proposition

presents the equilibrium at :

PROPOSITION 1: Agents’ holdings of artworks at are and . In

addition, the value of is given by:

(14)

with

(15)

and

(16)

where is the standard normal probability (cumulative) density function of , with

and .

Proof: Appendix.

Proposition 1 shows that there are three components of the price of artworks at . The

component inside the first set of round brackets in equation (14),

18
 , is the expected value of the non-optimism effect of

(see equation (8)). The component is the resale option, which is the expected value of

the 'optimism' effect of (see equation (9)). The resale option reflects that, in spite of there not

being an 'optimism' effect on the art price at , still contains a speculative component. The

resale option captures the fact that agents anticipate there being a chance of 'optimism' at , as

a result of which one agent type would value artworks much more highly than the other.

It is important to note that the resale option has the format of one half of an option strangle

strategy, with a payoff that is described in Figure 2. This option strangle is formed by a put option

and a call option, with the underlying asset being the stochastic component of the difference in

beliefs, . The put option has a strike price , while the call option has a strike price (see

Lemma 1). The last element of in Proposition 1, , captures the price discount

associated with the cost of holding artworks and the risk premium, since agents hold artworks

between and .

[Insert Figure 2 here]

PROPOSITION 2: (i) If agents are risk-neutral (i.e. ), disagreement increases the price of

artworks at . This is because the value of the resale option goes up with and (i.e.

and ), which induces an increase in .

(ii) If agents are risk-averse (i.e. ), disagreement does not necessarily increase . This is

because increases in and induce two effects. First, the value of the resale option increases with

and (as in the case when agents are risk-neutral). Second, the variance of also increases

with and (i.e. and ), which induces a reduction in ,

since agents require a larger price discount ‒ a risk premium ‒ for holding artworks between

and . Thus, depending on the market conditions, sometimes the former effect is

stronger than the latter, while at other times we can observe the opposite.

19
 (iii) The sum of the price change variance across periods always increases with and . In

addition, the expected turnover of artworks between periods goes up with , while the expected

turnover rate increases with if .

Proof: Appendix.

Figure 3 illustrates the impact of disagreement on art prices, the expected turnover rate and

the variance of price changes described in Proposition 2. The first part of Proposition 2 is consistent

with the theoretical model of Penasse and Renneboog (2018), with risk-neutral agents, short-sale

constraints and heterogeneous beliefs. Penasse and Renneboog (2018) show that art prices

increase with the magnitude of the stochastic disagreement, due to an increase in the value of the

resale option.

[Insert Figure 3 here]

The second part of Proposition 2 is interesting, because it changes the traditional view that

heterogeneous beliefs always increase art prices. This second part includes the concept of risk

aversion in artwork valuation. As explained in the introduction, the intuition behind this result is

that increases in the magnitude and volatility of the stochastic disagreements augment the chances

of observing an 'optimism' effect at , which also augments the variance of . This growth in

the variance of causes agents to require a larger price discount to hold this risky asset (see the

last term of equation (14)).

The intuition behind the third part of Proposition 2 is simple. The sum of the price change

variance across periods is

, which increases with the disagreement, as explained in

the second part of Proposition 2. In addition, the largest level of turnover rate is observed when

there is an 'optimism' effect at (i.e. second and third branches in Figure 1). Thus, the expected

turnover rate increases as the heterogeneity of beliefs goes up, since disagreement augments the

chances of observing the 'optimism' effect.

20
 PROPOSITION 3: (i) If agents are risk-neutral (i.e. ), then neither the price of artworks at

, the sum of the price change variance across periods, nor the expected turnover rate is

affected by .

(ii) If agents are risk-averse (i.e. ), the price of artworks at is not necessarily reduced

as rises, since and . Furthermore, an increase

in the value of induces a reduction in the sum of the price change variance across periods and

the expected turnover rate between and .

Proof: Appendix.

Figure 4, left-hand side, provides an example of the effect of a correlation between art

lovers' wealth and the 'emotional' dividend on the art market at , which is described in

Proposition 3. The first part of Proposition 3 is a consequence of the fact that the term

disappears from the model when . In relation to the second part of Proposition 3 (with ),

this statement is explained by the fact that the chances of observing an 'optimism' effect at , in

which art lovers will buy up everything in the art market, decrease as increases. This is

because an increase in the value of reduces the diversification features of art lovers, which is

reflected in a reduction in the art lovers' valuation of artworks (see equation (4)). Thus, the resale

option shrinks in value as rises, which induces a reduction in .

Additionally, given that chances of observing an 'optimism' effect from art lovers decrease

as goes up, the variance of is also reduced as rises ( ). A reduction

in increases as the price discount for holding artworks between and

shrinks. Hence, the net effect on of a rise in can be an increase or a decrease, depending on

the market conditions. Moreover, since the probability of observing art lovers buying up the entire

market decreases as goes up, the expected turnover rate is also reduced as rises.

[Insert Figure 4 here]

21
 PROPOSITION 4: (i) If agents are risk-neutral (i.e. ), decreases as the fixed supply of

artworks goes up, since .

(ii) If agents are risk-averse (i.e. ), an increase in does not necessarily decrease . This is

because , but we also have that .

(iii) The sum of the price change variance across periods is reduced as increases, while the

expected turnover rate only decreases as increases if .

Proof: Appendix.

Figure 4, right-hand side, presents an example of the impact of the supply of artworks on

the art market at stated in Proposition 4. The first part of Proposition 4 shows that

decreases as increases, since the availability of artworks negatively affects the resale option. For

example, as explained in the third branch of Figure 1, we observe an 'optimism' effect from art

lovers, when the minimum price they would pay for artworks (i.e.

, with in

equation (4)) is larger than the maximum price speculators would pay (i.e. / ,

with in equation (5)). Therefore, if increases, there are lower chances of observing an

'optimism' effect in which art lovers will buy up the whole art market. We can provide a similar

example for speculators, where an increase in also reduces the probability of an 'optimism' effect

stemming from this type of agent. Therefore, we have that .

In the second part of this proposition, since the chances of observing the 'optimism' effect

decrease as goes up, the variance of is also reduced. This reduction in the variance of (with

an increase in ) diminishes the price discount for holding artworks between and ,

which moves upward. In relation to the last part of Proposition 4, since the chances of observing

the 'optimism' effect decrease as goes up, this also reduces the expected turnover rate, as was

explained previously.

22
 PROPOSITION 5: (i) If agents are risk-neutral (i.e. ), then neither the price of artworks at

, the sum of the price change variance across periods, nor the expected turnover rate is

affected by .

(ii) If agents are risk-averse (i.e. ), the price of artworks at is not necessarily reduced

as rises, since and .

(iii) The sum of the price change variance across periods is not necessarily increased as rises,

since and .

(iv) An increase in the value of induces an increase in the expected turnover rate if

Proof: Appendix.

Figure 5 shows the effect on art pricing of a rise in the correlation between the harmful

impact of art forgery and the ‘emotional’ dividend, , that was described in Proposition 5. The

first part of Proposition 5 comes about because the term disappears from the model when

. The second part of Proposition 5 is more interesting. Albeit that an increase in the expected

harmful impact of forgery, , induces a reduction in art prices at (i.e. in equation

(14)), the increase in the correlation between art forgery and the ‘emotional’ dividend, , does

not necessarily increase (or reduce) the prices of artworks.

The intuition behind the result in the second part of Proposition 5, in relation to rises in

, is due to the interaction of different effects on art pricing that go in opposite directions. Firstly,

an increase in such correlation increases the resale option. This can be observed in the strike prices

(i.e. and ) of the option strangle strategy that describes the resale option in Figure 2. We can

observe that call and put options are more in-the-money when is higher (which means there

are more chances of observing an 'optimism' effect). Thus, the size of the bubble generated by the

resale option goes up when does.

23
 However, there is also a negative effect on art prices of a rise in , through . This

is because, as explained in the previous paragraph, the chances of observing the 'optimism' effect

increase as does; thus, the variance of also goes up. This increase in the variance of , when

rises, raises the price discount stemming from the risk premium for holding artworks between

and , which moves down.

The third part of Proposition 5 is also remarkable. We know that the sum of the price

change variance across periods is

. Thus, on the one hand, a rise in reduces

the price volatility of (i.e. ), which was

explained after Lemma 1. This is because, when increases, if the ‘emotional’ dividend goes up

(which should induce an increase in the value of artworks at ), there will be more chance of art

forgery and thus also increases (bringing the value of artistic objects back down). Thus, a rise in

generates price stability in .

On the other hand, an increase in also increases the price volatility of (

), as described in the second part of Proposition 5. Thus, the price change variance across

periods is not necessarily increased as rises. Finally, in the fourth part of Proposition 5, given

that the probability of observing the 'optimism' effect is augmented when goes up, this also

increases the expected turnover rate, since one of the agents can buy up the entire market.

4 Conclusion

This article analyzes the effect, on the market for artworks, of the following: art supply

constraints due to artist deaths; the relation between art collectors' wealth and the 'emotional'

value of artworks; and art forgery in the presence of risk-averse agents (when there are short-sale

constraints, heterogeneous beliefs, and additional benefits from the ownership of artworks,

24
induced by a luxury 'appetite', conspicuous consumption and/or social status). We show that there

are speculative bubbles in the price of artworks. Speculative bubbles increase in size with a

reduction in the supply of artworks, a more negative correlation between collectors' wealth and the

'emotional' value provided by artworks, a more positive correlation between the harmful impact of

forgery and the 'emotional' value of artworks, and an increase in belief disagreement.

Nevertheless, we also find that these sources of speculation increase the variance of the

price component related to speculative bubbles, which augments the risk premium that risk-averse

agents require in return for holding the artworks. Therefore, the net impact of speculation does not

necessarily increase the artworks' price. This has important implications for the art market, since it

changes the traditional view that speculation always augments art prices. Furthermore, we find that

the expected turnover rate and the price change variance of artworks in general increase with the

sources of speculation. These results are very relevant since artworks are currently important

alternative assets, which are also used as funding collateral and as a store of value.

Appendix

Proof of Lemma 1. Art lovers solve the following at :

(A1)

From the first-order condition, we obtain the demand function of art lovers:

(A2)

Similarly, the demand function of speculators is:

25
 (A3)

In addition, we know that there is a fixed supply of artworks, such that:

(A4)

Equations (A2)-(A4) represent a linear equation system with three equations and three

unknown variables (i.e. and ). Under short-sale constraints (i.e. and ),

this linear equation system provides three cases:

Case 1. This case is obtained when we solve the equation system and obtain that

and (i.e. the short-sale constraints for both agents are not bounded). In this case, we have:

(A5)

with

(A6)

Since and the condition for this case is that , where:

(A7)

Case 2. This case is observed when the minimum price that speculators would pay for

artworks (i.e. , when ) is

larger than the maximum price that art lovers would pay (i.e.

, when

26
 =0). Thus, this case is obtained when , where speculators buy up the entire art market.

Therefore, in this case we have:

(A8)

with

(A9)

Case 3. This case is obtained when the minimum price that art lovers would pay for

artworks in the economy (i.e.

), when = ) is larger than the maximum price that speculators would pay

(i.e. , when ). Thus, this case

is observed when , where art lovers buy up the whole art market. Therefore, in this case we

have:

(A10)

with

(A11)

These three cases show the price of artworks at can take three forms, given by

equation (A5) if , equation (A8) if and equation (A10) if . Thus, after

some algebra, we can write down a single expression that captures these three cases:

(A12)

which is the expression represented in equation (7). Q.E.D.

27
Proof of Proposition 1. Since agents have homogeneous beliefs at about the process that will

be followed by future disagreement at , we know that and

. Using equations (11) and (12),

(A13)

Given that we know that ,

(A14)

This provides the expression for the price of artworks and holdings at :

(A15)

with

(A16)

Therefore, we need to obtain the expressions for and . Firstly, let us analyze

the expectation term. From Lemma 1, we know the value of . Thus,

(A17)

where

(A18)

and

(A19)

28
 Equation (A18) only contains deterministic variables, but equation (A19) contains the

random variable . To find an expression for equation (A19), let us consider the following auxiliary

terms:

(A20)

In addition, let be the standard normal probability (cumulative) density function of .

Hence, we can re-write equation (A19) as:

(A21)

Consequently, by the properties and , we have:

(A22)

Q.E.D.

In relation to , we know that:

(A23)

because the term is a constant. Moreover, we know that

. Thus, we first calculate :

29
 (A24)

Additionally, we know that . Then,

(A25)

In relation to , from equation (A22),

(A26)

Therefore,

(A27)

Q.E.D.

Proof of Proposition 2. In the first part of Proposition 2, we need to show that

and . Using equation (15), we have:

(A28)

In addition, we know that . Therefore,

30
 (A29)

Thus, , because given that

by Assumption 2.

In relation to , we can also use equation (15):

(A30)

Q.E.D.

In the second part of Proposition 2, from equation (14) we have that:

(A31)

and

(A32)

Hence, we need to calculate and . We can use equation (16),

giving:

(A33)

and after some algebra, we have:

31
 (A34)

The expression in equation (A34) is always positive if , which is the case given Assumption 2.

Similarly to the way we proceeded for , we can develop an expression for

(A35)

which is also positive in the case that , which is the case given Assumption 2. Thus,

(A36)

and

(A37)

Therefore, and can be positive or negative.

Q.E.D.

In relation to the third part of Proposition 2, on the one hand, we know that

. Therefore, using equations

(A34) and (A35), and

32
 . On the other hand, the turnover rate is defined as

, which is equivalent to:

(A38)

Let us consider the auxiliary term:

(A39)

Hence, and also from the auxiliary variables defined in expression (A20), we have:

(A40)

Then, we have:

33
 (A41)

Moreover, we know that and .

Therefore,

(A42)

which is higher than zero when , which is the case given Assumption 2.

In relation to , we have:

(A43)

34
which is also higher than zero when given Assumption 2.

Q.E.D.

Proof of Proposition 3. The proof of the first part of Proposition 3 is easy to obtain since the term

disappears in the model when . In relation to the second part of Proposition 3, we need

to show that and . Note that:

On the one hand, using equation (15),

(A44)

On the other hand, and using equation (16), we have:

35
 (A45)

which is always negative given that . Then,

(A46)

Thus, the expression in equation (A46) can be positive or negative.

In relation to the sum of the price change variance across periods,

, we know that

1)/ , <0 from equation (A45). Finally, we need to show that 0 / , <0. Using

equation (A40) and , we have that:

36
 (A47)

which is negative when , which is the case given Assumption 2.

Q.E.D.

Proof of Proposition 4. We first need to show that . Using equation (15), we

have:

(A48)

Since , it follows that:

(A49)

Q.E.D.

In the second part of Proposition 4, we need to prove that . Using

equation (16), we have:

37
 (A50)

which is negative since . Hence,

(A51)

Therefore, can be positive or negative.

Q.E.D.

In relation to the third part of Proposition 4, firstly, we know that

. Then, using equation (A50),

. Secondly, in terms of the expected turnover rate:

38
 (A52)

which is negative when .

Q.E.D.

Proof of Proposition 5. Similarly to the proof of Proposition 3, the proof of the first part of

Proposition 5 is straightforward because the term disappears in the model when . In

terms of the second part of Proposition 5, we need to show that

which is directly obtained. In addition, we need to show that

and .Thus, as a first step, note that:

On the one hand, using equation (15),

39
 (A53)

On the other hand, and using equation (16), we have:

(A54)

which is positive since . Then,

(A55)

Thus, the expression in equation (A55) can be positive or negative.

In relation to the sum of the price change variance across periods,

. We know that , but

, thus can be increasing or

decreasing depending on the values of , and .

Finally, we need to show that .We know that:

and using equation (A40), we have that:

40
 (A56)

which is positive when .

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heterogenous, Journal of Economic dynamic and control, 22 (4), 597-626.

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 + , (1 + )
,1 = +
2 2 + 2
+ 2
2 ,
+ , (1 + )
,1 = 2 2
2 2 + ( + 2 , )
Non-optimism effect 1 , (1 + )
if 1 < < 2 1 = +
1+ 2 2
2 2
+ ( + 2 , )
2

Art lovers sit out of the market ,1 =0

Speculators participate in the market ,1 =
If: 1 1
1 =
1+ 2
2 2
+ ( + 2 , )
Optimism effect

,1 =
,1 =0
Art lovers participate in the market 1
Speculators sit out of the market 1 = + + , 1+
1+ 2
If: 2

with: + ( 2
+ 2
2 )
,
2 2
1 = + + 2 , , (1 + )
2 2
2 = + ( + 2 , ) , (1 + )

Figure 1. Non-optimism effect and optimism effect on the price of artworks at .

1 45
= 𝑄 + 2
2
 𝑃

𝑃𝑢 𝐶
Strangle
(Put + Call)

Speculators hold Art lovers hold

completely the completely the
art asset: art asset:
,1 = 0; ,1 = 𝑞 ,1 = ; ,1 = 0

1 2

with:
2 2
1 = + + 2 , , (1 + )
2 2
2 = + ( + 2 , ) , (1 + )

Figure 2. Payoff of the option strangle strategy that describes the resale option.

46
Figure 3. The effect of heterogeneous beliefs on prices, the sum of the price change variance across
periods and the expected turnover. In these plots, we assume three levels of risk aversion, which include
the case of risk neutrality: , and . In addition, we assume that =10,
, , , and . In the set of plots on the
left-hand side (where the x-axis reflects changes in ), we assume that . In the set of plots on the
right-hand side (where the x-axis reflects changes in ), we assume that .

47
Figure 4. The impact of a correlation between art lovers' wealth and the 'emotional' dividend, and the
supply of artworks on prices, the sum of the price change variance across periods and the expected
turnover. In these plots, we assume three levels of risk aversion, which include the case of risk neutrality:
, and . In addition, we assume that 10, ,
, and . In the set of plots on the left-hand side (where the x-axis
reflects changes in ), we assume that . In the set of plots on the right-hand side (where the x-axis
reflects changes in ), we assume that .

48
Figure 5. The impact of a correlation between art forgery and the 'emotional' dividend on prices, the
sum of the price change variance across periods and the expected turnover. In these plots, we assume
three levels of risk aversion, which include the case of risk neutrality: , and . In
addition, we assume that 10, , , , , r=0.05,
and .

49