Dynamic trading and asset prices: Keynes vs. Hayek

Cespa, G. & Vives, X. (2012). Dynamic trading and asset prices: Keynes vs. Hayek. Review of Economic Studies, 79(2), pp. 539-580. doi: 10.1093/restud/rdr040

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Abstract

We investigate the dynamics of prices, information, and expectations in a competitive, noisy, dynamic asset pricing equilibrium model with long-term investors. We argue that the fact that prices can score worse or better than consensus opinion in predicting the fundamentals is a product of endogenous short-term speculation. For a given positive level of residual pay-off uncertainty, if liquidity trades display low persistence, rational investors act like market makers and accommodate the order flow and prices are farther away from fundamentals compared to consensus. This defines a "Keynesian" region; the complementary region is "Hayekian" in that rational investors chase the trend and prices are systematically closer to fundamentals than average expectations. The standard case of no residual uncertainty and liquidity trading following a random walk is on the frontier of the two regions and identifies the set of deep parameters for which rational investors abide by Keynes' dictum of concentrating on an asset "long-term prospects and those only". The analysis also explains momentum and reversal in stock returns and how accommodation and trend-chasing strategies differ from these phenomena.

Item Type: Article
Additional Information: This is a pre-copyedited, author-produced PDF of an article accepted for publication in Review of Economic Studies following peer review. The version of record Cespa, G & Vives, X (2012). Dynamic trading and asset prices: Keynes vs. Hayek. Review of Economic Studies, 79(2), pp. 539-580. is available online at: http://dx.doi.org/10.1093/restud/rdr040
Uncontrolled Keywords: Average expectations, Efficient market hypothesis, Long- and short-term trading, Momentum, Opaqueness, Reversal
Subjects: H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Finance
URI: http://openaccess.city.ac.uk/id/eprint/7009

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