State-contingent Claims Research Articles

Rationing rules for risky claims

We study rationing rules in a scenario where individuals have state-contingent claims over a resource. The rules must allocate shares before the resolution of uncertainty. We begin by characterizing ex-ante rules based on how they handle the inherent uncertainty in individual claims. The key axiom is “No Penalty for Risk”, which states that the rule should not penalize an individual if a situation differs from another only in terms of the presence of risk in the former situation compared to the latter situation’s riskless claim. Regarding ex-post characterizations, our primary axiom is “Indifference to Independent Combination of Gambles”. If an individual has risk-neutral expected utility preferences, any rule that makes them indifferent between a given rationing problem and a corresponding independent combination of gambles between a degenerate gamble and a zero game (any rationing problem with a zero endowment) must be in the ex-post form. Lastly, we provide a partial comparative static result that supports the claim that individuals generally prefer ex-ante rules to ex-post rules when the resource level is low enough.

Risk-Sharing Externalities

Financial crises typically occur because firms and financial institutions are highly exposed to aggregate shocks. We propose a theory to explain these exposures. We study a model where entrepreneurs can issue state-contingent claims to consumers. Even though entrepreneurs can use these instruments to hedge negative shocks, they do not necessarily do so because insuring against these shocks is expensive, as consumers are also harmed by them. This effect is self-reinforcing because riskier balance sheets for entrepreneurs imply higher income volatility for the consumers, making insurance more costly in equilibrium. We show that this feedback is quantitatively important and leads to inefficiently high risk exposure for entrepreneurs.

Multi-asset Noisy Rational Expectations Equilibrium with Contingent Claims

Abstract We study a noisy rational expectations equilibrium in a multi-asset economy populated by informed and uninformed investors and noise traders. The assets can include state contingent claims such as Arrow–Debreu securities, assets with only positive payoffs, options or other derivative securities. The probabilities of states depend on an aggregate shock, which is observed only by the informed investor. We derive a three-factor CAPM with asymmetric information, establish conditions under which asset prices reveal information about the shock, and show that information asymmetry amplifies the effects of payoff skewness on asset returns. We also find that volatility derivatives make incomplete markets effectively complete, and their prices quantify market illiquidity and shadow value of information to uninformed investors.

Informational efficiency and behaviour within in-play prediction markets

Studies of financial market informational efficiency have proven burdensome in practice, because it is difficult to pinpoint when news breaks and is known by some or all the participants. We overcome this by designing a framework to detect mispricing, test informational efficiency and evaluate the behavioural biases within high-frequency prediction markets. We demonstrate this using betting exchange data for association football, exploiting the moment when the first goal is scored in a match as major news that breaks cleanly. There are pre-match and in-play mispricing and inefficiency in these markets, explained by reverse favourite-longshot bias (favourite bias). The mispricing tends to increase when the major news is a surprise, such as a goal scored by a longshot team late in a match, with the market underestimating their chances of going on to win These results suggest that, even in prediction markets with large crowds of participants trading state-contingent claims, significant informational inefficiency and behavioural biases can be reflected in prices.

Equilibrium in incomplete markets with differential information: A basic model of generic existence

The paper demonstrates the generic existence of general equilibria in incomplete financial markets with asymmetric information. The economy has two periods and an ex ante uncertainty over the state of nature to be revealed at the second period. Securities pay off in cash or commodities at the second period, conditionally on the state of nature to be revealed. They permit transfers across periods and states, which are typically insufficient to span all state contingent claims to value, whatever the spot price to prevail. Under the standard smooth preference and perfect foresight assumptions, the paper shows that equilibria exist, except for a closed set of measure zero of securities and endowments. This theorem generalizes Duffie and Shafer’s (1985) to arbitrary financial and information structures. The equilibrium prices are consistent with any collection of state prices and norm values on spot markets. This refinement permits to extend to asymmetric information Cass’ (1984) theorem that any collection of state prices supports an equilibrium on purely financial markets.

Parametric Rules for State Contingent Claims

We study bankruptcy rules in a setting where individuals have state contingent claims. A rule must distribute shares before uncertainty resolves. Within a wide class of parametric rules, we first characterize rules of ex-ante form in terms of the way that the rule processes inherent uncertainty in the individual claims. The key property is: No Penalty for Risk. It says that the rule does not penalize an individual in a situation that differs from another only in terms of the this individual's claim in that the former situation has a risky version of the riskless claim in the latter situation. With regard to the ex-post characterization, our key property is: Indifference to Independent Combinations. It says that if an individual is risk neutral with expected utility preferences then any rule that makes her indifferent between any bankruptcy problem and a corresponding independent combination of gamble between a degenerate gamble and a zero game (any bankruptcy game with zero endowment) forces the rule to be in the ex-post form. Finally, a partial comparative static result is provided which formalizes the claim that individuals generally and ex-ante rules more appealing when the level of the resource is suffciently low.

Commodity-linked bonds as an innovative financing instrument for African countries to build back better

<abstract> <p>Commodity-linked bond, a type of state contingent claims, presents an innovative tool for African countries to mobilize resources on the international capital markets. Given their colossal financing needs, which has been worsened by the COVID-19 pandemic, African countries need to put in place innovative financing mechanisms to support their development frameworks for building back better. The issuing of this type of bond could provide an opportunity for commodity-producing African countries to hedge against fluctuations in their export earnings. The results show that the value of a commodity-linked bond increases as the price of the commodity indexed to the bond rises, suggesting that African countries should issue debt contracts that are tied to their export commodities so that their debt declines with plummeting export prices (or export revenues). A simple portfolio rule derived suggests that countries should issue more commodity-linked bonds than conventional debt if the variance of the portfolio is greater than twice the spread between the expected total return of the conventional debt and the commodity-linked bond. This rule supports the view that African countries' debt-service payments, for debt issued in the form of commodity-linked bonds, would decline whenever the price of their export commodities decline thus lightening their debt load.</p> </abstract>

Informational Efficiency and Price Reaction Within In-Play Prediction Markets

Studies of financial market informational efficiency have proven burdensome in practice, because it is difficult to pinpoint when news breaks and is known by some or all the participants. We overcome this by designing a framework to detect mispricing, test informational efficiency and evaluate the behavioural biases within high-frequency prediction markets. We demonstrate this using betting exchange data for association football, exploiting the moment when the first goal is scored in a match as major news that breaks cleanly. There are pre-match and in-play mispricing and inefficiency in these markets, explained by reverse favourite-longshot bias (favourite bias). The mispricing tends to increase when the major news is a surprise, such as a goal scored by a longshot team late in a match, with the market underestimating their chances of going on to win. These results suggest that, even in prediction markets with large crowds of participants trading state-contingent claims, significant informational inefficiency and behavioural biases can be reflected in prices.

Employing Decentralized Trading Protocol (P2P) to Optimize Assets Allocation

As it is the power of that gives occasion for the division of labor, so the extent of this division must always be limited by the extent of this power, (Adam Smith, 1776, Book 1, Chapter. 3). This paper deals with innovations in technology that have the potential to increase the power of exchanging by making decentralized P2P barter trading protocol operational in certain markets. The unprecedented growth of the market in terms of the variety of goods and services, the number of traders and the locations in which they trade make decentralized trading protocol (exchanging) more important than ever. Economic theory suggests that the optimal exchanging system is a decentralized P2P barter trading in state contingent claims on current and future consumption or in securities that represent such claims. Until now decentralized trading protocols were not possible and global trade is carried out through centralized fiat money as a medium of exchange. Fiat money contributes to a market of monopolistic competition due to the power and opportunistic behavior of governments that issue money and of central banks that manage the money. Blockchain and decentralized trading technologies make it possible to replace centralized fiat money as medium of exchange where the media of exchange are tokens registered on blockchains. The tokens represent claims on current and future consumption. Decentralized trading protocols implemented on blockchain the distributed ledger technology are still in nascent stage, but once applied even to a small and limited segment of the market they are likely to expand and to contribute to optimal asset allocation in the market as a whole.

Social Exclusion, Ambiguity and (IR)rationality

This working paper extends the methodology of non-smooth affective portfolio theory (APT) for eliciting (IR)rational preferences of investors endowed with continuous quasilinear utility functions, where assets are portfolios of risky and ambiguous state-contingent claims. The elicitation is a solution of the affective Afriat inequalities. Solving the smooth affective Afriat inequalities is Np-hard. The proposed extension is a methodology for the elicitation of (IR)rational preferences of individuals endowed with random continuous quasilinear utility functions defined over finite subsets of discrete social goods as a refutable model of social exclusion in the incomplete markets for social goods. The methods of elicitation are generalized estimating equations (GEE) and alternating logistic regression (ALR).

Semi-nonparametric approximation and index options

In an arbitrage-free securities market, all state-contingent claims and the stochastic discount factors can be approximated appropriately by index options with a semi-nonparametric method. These index options are constructed by efficient algorithms and uniform approximation error under these efficient algorithms are derived. This paper suggests a method to examine state-contingent claims and stochastic discount factors using index options in financial market regardless the market is complete or not.

The financial market: not as big as you think

In a general multiperiod financial market, we show that the market trading prices at intermediate dates of some securities with simple specifications, either compound call option or portfolios of index options, reveal sufficient information from the terminal date to intermediate dates; therefore, these simple securities dynamically span and complete the entire space of all state-contingent claims. We further demonstrate that those specifications of state-contingent claims are the simplest ones to dynamically span all state-contingent claims. Our results do not depend on agents’ risk-preference and basic asset’s stochastic price process. Therefore, the financial market might be not as big as we think.

Proportional rules for state contingent claims

We consider rationing problems where the claims are state contingent. Before the state is realized individuals submit claims for every possible state of the world. A rule distributes resources before the realization of the state of the world. We introduce two natural extensions of the proportional rule in this framework, namely, the ex-ante proportional rule and the ex-post proportional rule, and then we characterize them using standard axioms from the literature.

The impact of transaction costs on state-contingent claims mispricing

We analyze the impact that transaction costs have on asset mispricing in state-contingent claims markets. In particular, we examine betting markets, in which, it has been argued, transaction costs cause the favorite-longshot bias, a pricing anomaly analogous to the volatility smile in options markets. By using a heterogeneous agents model, we prove that transaction costs alone cannot cause mispricing. Also, we run agent-based simulations to character- ize the response of market prices to increments in transaction costs. We find that transaction costs have a significant impact on market inefficiency, by amplifying existing mispricing both directly, influencing market prices, and indirectly, inducing a non-linear response from the agents.

Intermediation Markups and Monetary Policy Passthrough

We introduce intermediation frictions into the classical monetary model with fully flexible prices. Trade in financial assets happens through intermediaries who bargain over a full set of state contingent claims with their customers. Monetary policy is redistributive and affects intermediaries' ability to extract rents; this opens up a new channel for transmission of monetary shocks into rates in the wider economy, which may be labelled the markup channel of monetary policy. Passthrough efficiency depends crucially on the anticipated sensitivity of future monetary policy to future stock market returns (the Central Bank Put). The strength of this put determines the room for maneuver of monetary policy: when it is strong, monetary policy is destabilizing and may lead to market tantrums where deteriorating risk premia, illiquidity and markups mutually reinforce each other; when the put is too strong, passthrough becomes fully inefficient and a surprise easing even begets a rise in real rates.

It Takes All Sorts: A Heterogeneous Agent Explanation of State-Contingent Claims Mispricing

Finding what causes pricing anomalies is an important step towards improving market efficiency. The favourite-longshot bias is one of the longest-standing pricing anomalies in state-contingent claims markets. However, existing models are unable to capture its full complexity. We develop a game-theoretic model of heterogeneous agents in a fixed-odds market. Comprehensive analysis using market data and agent-based simulations demonstrate that our model explains real market behaviour, including that of the market maker, better than existing theories. This model can be used to better understand the relation between market ecology and mispricing in broader contexts such as option and prediction markets.

The Impact of Transaction Costs on State-Contingent Claims Mispricing

We analyze the impact that transaction costs have on asset mispricing in state-contingent claims markets. In particular, we examine betting markets, in which, it has been argued, transaction costs cause the favorite-longshot bias, a pricing anomaly analogous to the volatility smile in options markets. By using a heterogeneous agents model, we prove that transaction costs alone cannot cause mispricing. Also, we run agent-based simulations to characterize the response of market prices to increments in transaction costs. We find that transaction costs have a significant impact on market inefficiency, by amplifying existing mispricing both directly, influencing market prices, and indirectly, inducing a non-linear response from the agents.

Earnings and hindsight bias: An experimental study

We conduct prediction experiments where subjects estimate, and later reconstruct probabilities of upcoming events. Subjects also value state-contingent claims on these events. We find that hindsight bias is greater for events where subjects earned more money.

Discovering a Profitable Trading Strategy in an Apparently Efficient Market: Exploiting the Actions of Less Informed Traders in Speculative Markets

Abstract: This study explores the extent of mispricing in a market for state contingent claims that is commonly believed to be efficient, the UK horserace betting market. We develop conditional logit models for weekend and weekday markets and show that prices are inefficient at weekends when the presence of a larger proportion of less informed bettors results in mispricing. A Kelly investment strategy focused on high probability outcomes in such markets yields considerable positive returns. We identify the need for research exploring the implications for information suppliers and users, regulators and operators in wider financial markets.

Revealing Weak‐Form Inefficiency in a Market for State Contingent Claims: The Importance of Market Ecology, Modelling Procedures and Investment Strategies

This paper examines the degree to which current prices discount historical prices in a market for state contingent claims. Conditional logit analysis is employed to predict winning probabilities, based on market prices in a betting market. These are used, together with various wagering strategies to yield substantial abnormal returns. Consequently, in contrast to the existing literature, the results suggest that the market is not weak form efficient. The disparity with previous efficiency studies highlights the importance of considering market ecology and of adopting an appropriate modelling procedure and investment strategy to fully exploit information contained in market prices.