The Pricing of Composition Uncertainty

50 Pages Posted: 16 Oct 2018 Last revised: 20 Nov 2018

See all articles by Nihad Aliyev

Nihad Aliyev

University of Technology Sydney (UTS) - School of Finance and Economics

Xuezhong He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School; Financial Research Network (FIRN)

Date Written: November 19, 2018

Abstract

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

Aliyev, Nihad and He, Xue-Zhong 'Tony', The Pricing of Composition Uncertainty (November 19, 2018). Available at SSRN: https://ssrn.com/abstract=3254882 or http://dx.doi.org/10.2139/ssrn.3254882

Nihad Aliyev (Contact Author)

University of Technology Sydney (UTS) - School of Finance and Economics ( email )

Haymarket
Sydney, NSW 2007
Australia

Xue-Zhong 'Tony' He

University of Technology Sydney (UTS) - Finance Discipline Group, Business School ( email )

Haymarket
Sydney, NSW 2007
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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