The Pricing of Composition Uncertainty
50 Pages Posted: 16 Oct 2018 Last revised: 20 Nov 2018
Date Written: November 19, 2018
The "quant crisis" of 2007 and subsequent unfolding of the global financial crisis highlighted the importance of the "crowded-trade" problem (not being able to know how many others are taking the same position). To investigate the crowded trading, we present a model in which informed and uninformed traders face uncertainty about the composition of traders (composition uncertainty). We characterize the equilibrium in both the information and financial markets. Composition uncertainty distorts traders' information acquisition, demands, and perceived equity premium, resulting in a security price mispricing. The model helps to understand a linkage between liquidity and asset prices, proposes plausible explanations for large price swings, and demonstrates how current regulations to enhance market efficiency may not work in the presence of composition uncertainty.
Keywords: Financial Market Microstructure, Rational Expectations Equilibrium, Composition Uncertainty, Asset Pricing, Value of Information
JEL Classification: D82, G12, G14
Suggested Citation: Suggested Citation