Shorting in Speculative Markets

41 Pages Posted: 18 May 2017 Last revised: 3 Apr 2018

Marcel Nutz

Columbia University

Jose A. Scheinkman

Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: March 28, 2018

Abstract

We propose a continuous-time model of trading with heterogeneous beliefs. Risk-neutral agents face quadratic costs-of-carry on positions and thus their marginal valuation of the asset decreases with the size of their position, as it would be the case for risk-averse agents.

In the equilibrium models of heterogeneous beliefs that followed the work by Harrison and Kreps, investors are risk-neutral, short-selling is prohibited and agents face constant marginal costs of carrying positions. The resulting resale option guarantees that the equilibrium price exceeds the price of the asset in a static buy-and-hold model where speculation is ruled out and this difference is identified as a bubble. Our model features three novelties to this literature. First, increasing marginal costs entail that the price depends on asset supply. Second, in addition to the resale option, agents also value an option to delay, and this may cause the market to equilibrate below the buy-and-hold price. Third, we introduce the possibility of short-selling.

Our model shows that when shorting is very costly, price formation is dominated by optimists and pessimists' views are hardly reflected. On the other hand, an unexpected decrease in shorting costs may lead to the collapse of a bubble; this links the financial innovations that facilitated shorting of mortgage backed securities to the subsequent collapse of prices relative to fundamentals. We use a Hamilton-Jacobi-Bellman equation of a novel form to describe the equilibrium of our model and derive comparative statics results.

Keywords: Speculation, Heterogeneous Beliefs, Asset-Supply, Resale Option, Delay Option, Shorting, Bubble-Implosion

JEL Classification: G1, G12, G14, G18

Suggested Citation

Nutz, Marcel and Scheinkman, Jose A., Shorting in Speculative Markets (March 28, 2018). Available at SSRN: https://ssrn.com/abstract=2969112 or http://dx.doi.org/10.2139/ssrn.2969112

Marcel Nutz

Columbia University ( email )

Jose A. Scheinkman (Contact Author)

Columbia University ( email )

420 W. 118th Street
New York, NY 10027
United States

HOME PAGE: http://www.princeton.edu/~joses

Princeton University - Department of Economics ( email )

26 Prospect Avenue
Princeton, NJ 08544
United States
609-258-4020 (Phone)
609-258-6419 (Fax)

HOME PAGE: http://www.princeton.edu/~joses

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Register to save articles to
your library

Register

Paper statistics

Downloads
161
rank
163,735
Abstract Views
815
PlumX