Asset Pricing When Trading Is for Entertainment
Review of Behavioral Finance, Forthcoming
67 Pages Posted: 23 May 2016 Last revised: 30 Apr 2018
Date Written: June 12, 2017
High levels of turnover in financial markets are consistent with the notion that trading, like gambling, yields direct utility to some agents. We show that the presence of these agents attenuates covariance risk pricing and volatility, and implies a negative relation between volume and future returns. Since psychological literature indicates that the desirability of a gamble arises from the ex ante volatility of the outcome, we propose that agents derive greater utility from trading more volatile stocks. These stocks earn lower average returns in equilibrium, although the risk premium on the market portfolio is positive. We then consider a dynamic setting where agents’ utility from trading increases when they make positive profits in earlier rounds (due, for example, to an endowment effect). This leads to “bubbles,” i.e., disproportionate jumps in asset returns as a function of past prices, higher volume in up markets relative to down markets, as well as a leverage effect, wherein down markets are followed by higher volatility than up markets.
Keywords: Trading, Volume, Gambling, Covariance Risk
JEL Classification: G00, G12, G14
Suggested Citation: Suggested Citation