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“This book develops the conceptual foundations required for the analysis of markets with asymmetric information, and uses them to provide a clear survey and synthesis of the theoretical literature on bubbles, market microstructure, crashes, and herding in financial markets. The book is not only useful to the beginner who requires a guide through the rapidly developing literature, but provides insight and perspective that the expert will also appreciate.” Michael Brennan Irwin and Goldyne Hearsh Professor of Banking and Finance at the University of California, Los Angeles, and Professor of Finance at the London Business School President of the American Finance Association, 1989 “This book provides an excellent account of how bubbles and crashes and various other phenomena can occur. Traditional asset pricing theories have assumed symmetric information. Including asymmetric information radically alters the results that are obtained. The author takes a complex subject and presents it in a clear and concise manner. I strongly recommend it for anybody seriously interested in the theory of asset pricing.” Franklin Allen Nippon Life Professor of Finance and Economics at the Wharton School, University of Pennsylvania President of the American Finance Association, 2000 “This timely book provides an invaluable map for students and researchers navigating the literature on market microstructure, and more generally, on equilibrium with asymmetric information. It will become highly recommended reading for graduate courses in the economics of uncertainty and in financial economics.” Hyun Song Shin Professor of Finance at the London School of Economics This page intentionally left blank ebook3600.com Asset Pricing under Asymmetric Information Bubbles, Crashes, Technical Analysis, and Herding MARKUS K. BRUNNERMEIER 3 OXFORD UNIVERSITY PRBSS Great Clarendon Street, Oxford 0x2 6DP Oxford University Press is a department of the University of Oxford. It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Bangkok Buenos Aires Cape Town Chennai Dar es Salaam Delhi Hong Kong Istanbul Karachi Kolkata Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi Sao Paulo Shanghai Taipei Tokyo Toronto Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Published in the United States by Oxford University Press Inc., New York © Markus K. Brunnermeier 2001 The moral rights of the author have been asserted Database right Oxford University Press (maker) First published 2001 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose this same condition on any acquirer British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Brunnermeier, Markus Konrad. Asset pricing under asymmetric information: bubbles, crashes, technical analysis, and herding / Markus K. Brunnermeier. p. cm Includes bibliographical references and index. 1. Stock—Prices 2. Capital assets pricing model. 3. information theory in economics. I. Title HG4636 .878 2000 332.63'222-dc21 00-064994 ISBN 0-19-829698-3 3 5 7 9 10 864 Typeset by Newgen Imaging Systems (P) Ltd., Chennai, India Printed in Great Britain on acid-free paper by TJ. International Ltd., Padstow, Cornwall To Smita This page intentionally left blank CONTENTS List of figures ix Preface xi 1. Information, Equilibrium, and Efficiency Concepts 1.1. Modeling Information 1.2. Rational Expectations Equilibrium and Bayesian Nash Equilibrium 1 2 14 1.2.1. Rational Expectations Equilibrium 1.2.2. Bayesian Nash Equilibrium 14 16 1.3. Allocative and Informational Efficiency 2. No-Trade Theorems, Competitive Asset Pricing, Bubbles 2.1. No-Trade Theorems 2.2. Competitive Asset Prices and Market Completeness 2.2.1. Static Two-Period Models 2.2.2. Dynamic Models – Complete Equitization versus Dynamic Completeness 2.3 Bubbles 2.3.1. Growth Bubbles under Symmetric Information 2.3.2. Information Bubbles 3. Classification of Market Microstructure Models 3.1. Simultaneous Demand Schedule Models 3.1.1. Competitive REE 3.1.2. Strategic Share Auctions 3.2. Sequential Move Models 3.2.1. Screening Models à la Glosten 3.2.2. Sequential Trade Models à la Glosten and Milgrom 3.2.3. Kyle-Models and Signaling Models 4. Dynamic Trading Models, Technical Analysis, and the Role of Trading Volume 4.1. Technical Analysis – Inferring Information from Past Prices 4.1.1. Technical Analysis – Evaluating New Information 4.1.2. Technical Analysis about Fundamental Value 21 30 30 37 38 44 47 48 55 60 65 65 72 79 79 87 93 98 99 100 103 viii Contents 4.2. Serial Correlation Induced by Learning and the Infinite Regress Problem 4.3. Competitive Multiperiod Models 4.4. Inferring Information from Trading Volume in a Competitive Market Order Model 4.5. Strategic Multiperiod Market Order Models with a Market Maker 5. Herding and Informational Cascades 5.1. Herding due to Payoff Externalities 5.2. Herding due to Information Externalities 5.2.1. Exogenous Sequencing 5.2.2. Endogenous Sequencing, Real Options, and Strategic Delay 5.3. Reputational Herding and Anti-herding in Reputational Principal–Agent Models 5.3.1. Exogenous Sequencing 5.3.2. Endogenous Sequencing 6. Herding in Finance, Stock Market Crashes, Frenzies, and Bank Runs 6.1. Stock Market Crashes 6.1.1. Crashes in Competitive REE Models 6.1.2. Crashes in Sequential Trade Models 6.1.3. Crashes and Frenzies in Auctions and War of Attrition Games 6.2. Keynes’ Beauty Contest, Investigative Herding, and Limits of Arbitrage 6.2.1. Unwinding due to Short Horizons 6.2.2. Unwinding due to Risk Aversion in Incomplete Markets Settings 6.2.3. Unwinding due to Principal–Agent Problems 6.3. Firms’ Short-Termism 6.4. Bank Runs and Financial Crisis 113 117 130 136 147 147 148 149 153 157 158 163 165 166 168 177 184 190 192 198 204 211 213 References 221 Index 233 LIST OF FIGURES 1.1 Inference problem from price changes 28 2.1 Illustration of common knowledge events 32 2.2 Illustration of Aumann’s agreement theorem 33 3.1 Average market price schedules under uniform and discriminatory pricing 85 3.2 Tree diagram of the trading probabilities 89 6.1 Price crash in a multiple equilibrium setting 174 6.2 Frenzy in an auction 188