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Abstract:
Noise traders are agents whose theoretical existence has been hypothesized as a way of solving certain fundamental problems in Financial Economics. We briefly review the literature on noise traders. This is an entry for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York), edited by Steven N. Durlauf and Lawrence E. Blume, forthcoming in 2008.

Abstract:
Noise traders are agents whose theoretical existence has been hypothesized as a way of solving certain fundamental problems in Financial Economics. We briefly review the literature on noise traders. The is an entry for The New Palgrave: A Dictionary of Economics, 2nd Edition (Palgrave Macmillan: New York), edited by Steven N. Durlauf and Lawrence E. Blume, forthcoming in 2008.

Noise Traders, Financial Markets, Market Efficiency

Abstract:
We model a financial firm that finances securities trading by issuing debt. Since there is a possibility of default, the interest rate offered on the debt includes a default premium. In this context the financial firm has to decide (i) how much debt to issue; and (ii) what its cost of capital is. In other words, we derive the cost-of-carry of a position in risky securities. Simultaneously with deciding its liability structure, the firm decides how much risk exposure to take on its assets. A central part of our analysis is to explain how the promised yield and the expected return to the debtholders are related to the cost of capital. Liability structure and investment policy are linked: for a given liability structure (with a given default premium) chosen in anticipation of particular investment opportunities, the financial firm may subsequently be unable to invest profitably in low risk assets even though they would have been profitable with a different capital structure. While the traditional analysis emphasizes the limited liability option conferred by bankruptcy, in our model the firm also considers that bankruptcy may damage its ability to survive and make future profits. Although we model a pure financial firm that finances securities trading with risky debt (such as a securities firm or hedge fund), the analysis can also be applied to the capital budgeting decisions of non-financial firms.

Abstract:
A fundamental role of financial markets is to gather information on firms' investment opportunities, and so help guide investment decisions in the real sector. We argue in this paper that firms' overinvestment is sometimes necessary to induce speculators in financial markets to produce information. If firms always cancel planned investments following poor stock market response, the value of their shares will become insensitive to information on investment opportunities, so that speculators will be deterred from producing information. We discuss several commitment devices firms can use to facilitate information production. We show that the mechanism studied in the paper amplifies shocks to fundamentals across stages of the business cycle.

Allocational Role of Price, Overinvestment, Price Informativeness, Business Cycles, Real Options, Financial Slack, Corporate Governance

Abstract:
A number of economists have supported the taxation of speculation in financial markets. We examine the welfare economics of such a tax in a model of a financial market where some agents have superior information and others have a hedging motive. We show that a tax on speculators may actually increase speculative profits. This occurs if the speculators' benefit from less informative prices offsets the cost of the tax. The effect on the welfare of other agents depends on how information revelation changes risk-sharing opportunities. It is possible for the introduction of a tax to cause a Pareto improvement.

Abstract:
A number of economists have supported the taxation of speculation in financial markets. We examine the welfare economics of such a tax in a model of trading in a nancial market where some agents have superior information. We show that in some cases a tax on speculators may actually increase speculative profits. This occurs if the speculators' benefit from less informative prices offsets the costs of the tax. The effect on the welfare of other agents depends on how revelation of information changes risk-sharing opportunities in the market. It is possible for the introduction of a tax to cause a Pareto improvement.

Abstract:
A fundamental role of financial markets is to gather information on firms' investment opportunities, and so help guide investment decisions. In this paper we study the incentives for information production when prices perform this allocational role. If firms cancel planned investments following poor stock market response, the value of their shares will become insensitive to information on investment opportunities, so that speculators will be deterred from producing information ex ante. Based on this insight, we derive the following main results. (1) Strategic complementarities in information production may arise, leading to multiple equilibria with different levels of information. (2) The incentive to produce information decreases when economic fundamentals deteriorate, leading to an amplification of shocks to fundamentals. (3) Incentives to produce information on assets in place are stronger than for new investment opportunities. (4) Firms will attract more information production and improve their ex-ante value by committing to overinvest.

Information Production, Real Investments, Financial Markets

Abstract:
Assume leaders cannot coerce followers: effective leaders can make changes because other people want to follow them, while ineffective leaders are unable to make changes because others will tacitly resist. Assume followers and leaders share the same objectives for successful change, but leaders have a limited tenure while followers are long lived. This time pressure for the leader can lead to outcomes in which lame ducks are unable to attract support towards the end of their tenure. We show that entrenchment, as opposed to early removal of lame ducks, can be optimal because it improves incentives ex ante. We also consider heterogeneity in the underlying talent of leaders. If good leaders are those with a higher chance of forming a plan, there is a trade-off involving the benefits of sacking inactive leaders, but in our specification it remains true that entrenchment is optimal.

Leadership, Entrenchment, Governance, Change

Abstract:
In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most 'informationally efficient' prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Abstract:
In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most "informationally efficient" prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Abstract:
Shareholders have imperfect control over the decisions of the management of a firm. We integrate a widely accepted version of the separation of ownership and control - Jensen's (1986) free cash flow theory - into a dynamic equilibrium model and study the effect of imperfect corporate control on asset prices and investment. We assume that firms are run by empire-building managers who prefer to invest all free cash flow rather than distributing it to shareholders. Sharefholders are aware of this problem but it is costly for them to intervene to increase earnings payouts. Our corporate finance approach suggests that the aggregate free cash flow of the corporate sector is an important state variable in explaining asset prices and investment. We show that the business cycle variation in free cash flow helps explain the cyclical behavior of interest rates and the yield curve. The stochastic variation in free cash flow sheds light on risk premia in corporate bonds and out-of-the-money put options. We show that the financial friction causes shocks to affect investment, and causes otherwise i.i.d. shocks to be transmitted from period to period. Unlike the existing macroeconomics literature on financial frictions, the shocks propagate through large firms and during booms.

Abstract:
In this Paper we use agency theory to study the active role of the CEO in the formulation of corporate strategy. We allow the agent (CEO) to play a role in defining the parameters of the agency problem, in an incomplete contracting model in which the agent can be rewarded based only on financial performance. Contracts can be renegotiated depending on the proposed strategy. We argue that CEOs will have an incentive to propose difficult, ambitious strategies for change. The principal (the shareholders) can mitigate this by pre-committing to pay high compensation regardless of the manager's chosen strategy, and will prefer to do so in times of change. In a less changeable environment, they will prefer to wait and see what strategy is chosen before setting compensation. In some circumstances, they will also prefer, if possible, to pre-commit never to pay high compensation.

Agency theory, executive compensation, free-cash-flow theory, strategic complexity

Abstract:
We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish 'actively doing nothing,' in this sense, from 'simply doing nothing.' Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.

Abstract:
No abstract is available for this paper.

Abstract:
No abstract is available for this paper.

Abstract:
We consider a model of the stock market with delegated portfolio management. All agents are rational: some trade for hedging reasons, some investors optimally contract with portfolio managers who may have stock-picking abilities, and portfolio managers trade optimally given the incentives provided by this contract. Managers try, but sometimes fail, to discover profitable trading opportunities. Although it is best not to trade in this case, their clients cannot distinguish "actively doing nothing," in this sense, from "simply doing nothing." Because of this problem: (i) some portfolio managers trade even though they have no reason to prefer one asset to another (noise trade). We also show that, (ii), the amount of such noise trade can be large compared to the amount of hedging volume. Perhaps surprisingly, (iii), noise trade may be Pareto-improving. Noise trade may be viewed as a public good. Results (i) and (ii) are compatible with observed high levels of turnover in securities markets. Result (iii) illustrates some of the possible subtleties of the welfare economics of financial markets.

Abstract:
I present a simple model in which it is possible that opening a new market makes everyone worse off. Trading volume in the new market may be arbitrarily large compared to the trading volume that results in the previously existing market. Some of the trading volume in the new market is attracted away from the pre-existing market, and some of it is new. The basic idea explored in the paper is of cross-market links between hedging and speculative demands: risk-averse speculators can use hedging in the new market to lower the risk of speculative positions in the pre-existing market. This causes a greater volume of speculative activity in the old market, leading some traders with pure hedging motives in that market to withdraw. Hence liquidity in the old market is reduced. These hedgers may then choose to hedge instead in the new market, even though the security traded there is an inherently inferior hedge for the risks they face.

Abstract:
I present a simple model in which it is possible that opening a new market makes everybody worse off. Unlike previous examples in the literature, the analysis does not rely on relative price changes of different consumption goods. This is shown in a standard framework in which uninformed traders with hedging needs interact with risk- averse informed traders in security markets where prices are set by a competitive market-making system. The paper emphasizes cross-market links between hedging and speculative demands: risk-averse arbitrageurs can hedge in the new market to lower the risk of speculative positions in the pre-existing market. This causes a greater incidence of speculative activity in the old market, leading some traders with pure hedging motives in that market to withdraw, so reducing liquidity in the old market. The general point argued here is that a risk-averse informed trader who believes an asset to be mispriced will typically be able to reduce the risk of speculating on his belief by hedging with other assets. The availability of such hedging instruments will in turn determine which types of speculative activity are of low risk, and this will influence the strategies to which traders will devote resources.

Abstract:
This paper studies the welfare economics of informed trading in a stock market. We model the effect of more informative prices on investment, given that this dependence will itself be reflected in equilibrium prices. We show that in rational expectations equilibrium with price-taking competitive behavior, and in the presence of risk-neutral uninformed agents, uninformed traders cannot lose money on average to informed traders. However, some agents with superior information may be willing to lose money on average in order to improve their hedging possibilities. We provide a parametric model that allows a closed-form solution and a complete welfare analysis. While a higher incidence of informed speculation always increases firm value through a more informative trading process, the effect on agents' welfare depends on how revelation of information changes risk-sharing opportunities in the market.