Rational Expectations Equilibrium Model Research Articles

Listening to the noise: On price efficiency with dynamic trading

This paper shows that, in the canonical dynamic rational expectations equilibrium model, public information about future noise trading is potentially detrimental to contemporaneous price efficiency. Our result supports concerns that social sentiment investing, sparked by growing availability of big data and advances in the way of processing it, exacerbates, rather than ameliorates, the negative impact of noise trading on price efficiency.

Disagreement about public information quality and informational price efficiency

Investors often hold differing opinions on public information quality. This paper shows that such investor disagreement provides a novel explanation for financial market dynamics around earnings announcements. We propose a rational expectations equilibrium model where investors disagree about the precision of a public signal, which separates a pre-news trading period from a post-news trading period. In equilibrium, investor disagreement about public signal precision diminishes informational price efficiency before the news, but enhances it afterward. Consequently, investor disagreement leads to a notable jump in informed trading around the news, a decline in abnormal trading volume before the news and a surge immediately after the news, and underreaction of stock price to announced earnings.

The impact of relative wealth concerns on wealth gap and welfare in a noisy rational expectations economy

We employ a noisy rational expectations equilibrium model to investigate the influence of relative wealth concerns on wealth gap and welfare. Our analysis reveals that the impact is sensitive to the exogeneity or endogeneity of information. When information is exogenous, the average wealth gap between high-precision and low-precision investors is either decreasing or, initially decreases and eventually increases in the degree of relative wealth concerns. Moreover, we identify two or three potential patterns regarding the monotonicity pattern of the welfare of low-precision and high-precision investors. However, when information becomes endogenous, the average wealth gap and welfare decrease.

Information Aggregation via Contracting

ABSTRACTWhen a group of investors with dispersed private information jointly invest in a risky project, how should they divide the project's profit? We show that a simple contract dividing profits in proportion to investors' risk tolerances may facilitate information aggregation by altering investors' risk‐taking incentives when they decide on how investment strategies respond to private information. Our results provide a contracting‐based approach for information aggregation, which is an alternative to learning from endogenous market variables (e.g., prices) via contingent schedules as seen in well‐known rational expectations equilibrium models.

Public disclosure with information sharing in financial market

We analyze a rational expectations equilibrium model that explores how information sharing among investors affects price volatility and firms’ disclosure quality. We derive closed-form expressions for the stock price and optimal disclosure quality as a function of network connectedness. We show that when investors are less risk-averse, price volatility will increase as information sharing among investors becomes more active, while managers will reduce the disclosure quality. When investors are more risk-averse, price volatility and disclosure quality both have a non-monotonous relationship with network connectedness. Our analysis highlights how technology, media, and capital market changes affect firms’ disclosure policies.

Private Information Dissemination and Noise Trading: Implications for Price Efficiency and Market Liquidity

Information is the basis for the sustainable and stable development of financial markets. Advanced internet technology has accelerated the dissemination of information. To investigate the impacts of private information dissemination on the sustainability of the financial market, we construct a rational expectation equilibrium (REE) model. The dissemination of private information favors noise traders who receive private information and weakens the advantage of informed traders who have direct access to private information, thus reducing noise-driven volatility and increasing fundamental-driven volatility, which is not conducive to the sustainability and stability of the financial market. Private information dissemination increases information asymmetry, reduces the number of noise traders in the market, decreases market liquidity, and hurts price efficiency for both exogenous and endogenous information acquisition, which is harmful to the sustainability of the financial market. Additionally, we numerically analyze the effects of private information on noise traders, market liquidity, and price efficiency. The numerical results are consistent with the theoretical analysis. The findings highlight the potential of private information dissemination to noise traders in financial market analysis. This study contributes to the analysis of financial market sustainability.

Illiquidity Comovement and Market Crisis.

This paper presents a rational expectation equilibrium model to explore how the financial contagion occurs between the unlinked markets that do not share common fundamentals. In the proposed model, the authors assume two of the three risky assets share no common fundamental factors, but are connected by one intermediate asset via cross fundamentals. Through this channel, investors transmit fundamental risk from one asset to another by dint of the cross fundamentals. This mechanism causes liquidity comovement and subsequently becomes a source of market crisis: Through the contagion mechanism, an initial liquidity shock in one asset can result in a drop tendency in liquidity and price informativeness for another asset. Such comovement in liquidity offers a new explanation for idiosyncratic assets in financial contagion.

Asset market equilibrium under rational inattention

We propose a noisy rational expectations equilibrium model of asset markets with rationally inattentive investors. We incorporate any finite number of assets with arbitrary correlation. We also do not restrict the signal form and show that investors optimally choose a single signal, which is a noisy linear combination of all risky assets. This generates comovement of asset prices and contagion of shocks, even when asset payoffs are negatively correlated. The model also provides testable predictions of the impact of risk aversion, aggregate risk, and information capacity on the security market line, the portfolio dispersion, and the abnormal return.

Stock-based pay, liquidity, and the role of market making

We study the role of stock market characteristics on managerial compensation. A risk averse manager exerts an unobservable effort that drives future firm value. The value cannot be used in the incentive contract because it realizes in the distant future and compensating the manager cannot be postponed until then. The stock price emerges endogenously because of trading by informed and uninformed traders in a standard competitive noisy rational expectations equilibrium model. We identify new “skin-in-the-game” and “information-overlap” terms in the weights the optimal incentive contract gives to the stock price and to public information. We derive novel comparative statics, e.g., the manager may receive more stock-based pay when traders' information becomes worse. The contract always uses public information except in the special case when uninformed traders are risk-neutral.

The Dynamic Effect of Public Information on Liquidity: From the Perspective of Limited Attention

The financial system is a complex system. The heterogeneous behaviors of investors further increase the degree of its complexity. In this paper, we develop a rational expectations equilibrium model to analyze the effect of public information on market efficiency and liquidity, especially in the market in which investors monitor the market imperfectly. When public information is partly reflected in equilibrium price or the uncertainty about the asset value is great, market efficiency increases with the increase of the precision of public information and the investors holding it. However, when the uncertainty about the fundamental value is small, the increase of the precision of public information worsens market liquidity. And in this market, with the increase of the investors acquiring public information, market liquidity first decreases and then increases. Overall, our results suggest that listed companies should disclose their information accurately by different channels as much as possible, and the regulators should enhance the supervision of information disclosure to enhance market efficiency and liquidity.

Wealth heterogeneity, information acquisition and equity home bias: Evidence from U.S. household surveys of consumer finance

• Equity home bias occurs along both extensive and intensive margins. • Wealthy US households are more likely to participate in the foreign stock market. • As investor wealth increases, portfolio share invested in foreign equities decreases. • Overall international diversification is increasing with wealth. • A noisy rational expectations equilibrium model with wealth heterogeneity, entry costs, and information processing can explain both margins. The well-known equity home bias has two components: an extensive and intensive margin. Using data on direct stock holdings of U.S. households, we find that the decision to participate in foreign stock markets depends on investor wealth, with richer investors more likely to participate (the extensive margin). We document a new finding: as investor wealth increases, the portfolio share invested in foreign equities tends to decrease (the intensive margin). A noisy rational expectations equilibrium model with wealth heterogeneity, entry costs, and endogenously chosen information processing capacity can generate the new negative relationship and help understand the U.S. household equity home bias along both margins.

What Do Interest Rates Reveal About the Stock Market? A Noisy Rational Expectations Model of Stock and Bond Markets

We propose a novel theory and provide supporting empirical evidence that lower long-term interest rates (e.g., because of ``quantitative easing'') harm informational and allocative efficiency. We develop a noisy rational expectations equilibrium model with an endogenous interest rate that investors use to update their beliefs about economic fundamentals. The interest rate reveals information about discount rates, allowing investors to extract more information about cashflows from stock prices. The precision of the interest-rate signal and, hence, stock-price informativeness increase in the interest rate. As a result, informational and allocative efficiency rise with bond and money supplies and with policy transparency.

On ESG Investing: Heterogeneous Preferences, Information, and Asset Prices

We study how environmental, social and governance (ESG) investing reshapes information aggregation and price formation. We develop a rational expectations equilibrium model in which traditional and green investors are informed about monetary and non-monetary risks but have distinct preferences over them. Because of the preference heterogeneity, traditional and green investors trade in opposite directions based on the same information and make the price noisier to each other. We show that an increase in the share of green investors and an improvement in the quality of non-monetary information can reduce overall price informativeness and increase firm's cost of capital. Our analyses provide a rich set of testable implications.

Funding Constraints and Informational Efficiency

Abstract We analyze a tractable rational expectations equilibrium model with margin constraints. We argue that constraints affect and are affected by informational efficiency, leading to a novel amplification mechanism. A decline in wealth tightens constraints and reduces investors’ incentive to acquire information, lowering price informativeness. Lower informativeness, in turn, increases the risk borne by financiers who fund trades, leading them to further tighten constraints faced by investors. This information spiral leads to (a) significant increases in risk premium and return volatility in crises, when investors wealth declines, (b) complementarities in information acquisition in crises, and (c) complementarities in margin requirements.

Loss aversion and market crashes

This study proposes a rational expectation equilibrium model of stock market crashes with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable. The model predicts nonlinear market depth and the result that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results are consistent with the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements that are not driven by major news events but coupled with a spillover effect between unrelated markets.

The Microstructure of Endogenous Liquidity Provision

We analyze a nonlinear rational expectations equilibrium model with an ex post endogenous liquidity provision decision. Speed and information technology advantages allow endogenous liquidity providers (ELPs) to switch between limit and market orders after observing private information. This significantly influences the adverse selection faced by designated market makers (DMMs), thereby generating a gap between liquidity supply from DMMs and liquidity demand by informed traders. As a result, endogenous liquidity provision leads to two equilibrium regimes with nonlinear price impacts and the possibility of market breaks. These breaks occur when ELPs switch from liquidity provision to liquidity consumption as a consequence of unexpected shocks. Increasingly similar information among ELPs reduces the risk of systematic liquidity withdrawals but intensifies the DMMs’ adverse selection cost. Our model is relevant to various plausible settings and can help to explain a variety of financial market outcomes.

Stock-Based Pay, Liquidity, and the Role of Market Making

We study the role of stock market characteristics on managerial compensation. A risk averse manager exerts an unobservable effort that drives future firm value. The value cannot be used in the incentive contract because it realizes in the distant future and compensating the manager cannot be postponed until then. Instead, the contract uses the stock price as well as public information about the future value of the firm. The stock price emerges endogenously because of trading by informed and uninformed traders in a standard competitive noisy rational expectations equilibrium model. It is well known that liquidity facilitates trading on private information. We identify a dark side of liquidity for incentive contracting. More liquidity makes the stock price less responsive to trading and hence, less sensitive to the manager's effort. Our model yields novel comparative statics, e.g., the manager may receive more stock-based pay when traders' information becomes worse. The contract always uses public information except in the special case when uninformed traders are risk-neutral.

The Short-Termism of Traders and Equilibrium Multiplicity

We investigate the impacts of the short-termism on multiple equilibria in a dynamic rational expectations equilibrium model. We find that short-termism is not the cause of equilibrium multiplicity but affects market quality of all equilibria. The liquidity, price efficiency and expected trading volume in high trading intensity equilibrium (HTIE) are higher than those in low trading intensity equilibrium (LTIE) no matter how myopic the informed traders are. As investors’ myopia degree increases, this difference between HTIE and LTIE becomes larger. The LTIE is always stable but the speed of convergence to new equilibrium is negatively related to the myopia degree of traders when an unexpected shock moves the price away from equilibrium. The opposite happens in HTIE.

Loss Aversion and Market Crashes

This study proposes a rational expectation equilibrium model of crashes in an economy with information asymmetry and loss averse speculators. We obtain a state-dependent linear optimal trading strategy, which makes the equilibrium price tractable for the first time in such an economy. The model predicts nonlinear market depth and the fact that small shocks to fundamentals (e.g., supply or informational shocks) can cause abrupt price movements. We demonstrate that short-sale constraints intensify asset price collapses relative to upward movements. The model also generates contagion between uncorrelated assets. These results reflect the main puzzling features observed during market crashes, namely abrupt and asymmetric price movements, not driven by major news events, coupled with a spillover effect between unrelated markets.

Customer Learning in Call Centers from Previous Waiting Experiences

Designing modern call centers requires an understanding of callers’ patience and abandonment behavior. Using a Cox regression analysis, we show that callers’ abandonment behavior may differ based on their contact history, and changes across their different contacts. We control for caller heterogeneity using a two-step grouped-fixed effect method. This analysis shows that differences in callers’ abandonment behavior are not only driven by their heterogeneity but also by differences in their beliefs about their delays affected by their contact history. As a result, callers’ beliefs about the waiting time distribution may not match the actual distribution in the call center, and the equilibrium condition in the rational expectation equilibrium assumption may not hold. To understand callers’ prior belief about the waiting time distribution, and to disentangle the impact of changes in their beliefs driven by their contact history from the impact of their intrinsic parameters, we use a structural estimation approach in a Bayesian learning framework. We estimate the parameters of this model from a call center data set with multiple priority classes. We show that in this call center, new callers who do not have any prior experience with the call center are optimistic about their delay in the system and underestimate its length irrespective of their priority classes. We also show that our Bayesian learning model not only has a better fit to the data set compared to the rational expectation equilibrium model but also outperforms the rational expectation equilibrium model in out-of-sample tests. Our Bayesian framework not only sheds light on callers’ learning process and their beliefs about their delays, but also could leverage callers’ contact history to provide personalized patience level for callers. This personalized information enables implementation of patience-based scheduling policies studied in the queueing literature.The online appendix is available at https://doi.org/10.1287/opre.2018.1738 .