Equilibration Under Competition in Smalls: Theory and Experimental Evidence

46 Pages Posted: 12 Aug 2006

See all articles by Peter Bossaerts

Peter Bossaerts

University of Melbourne - Department of Finance

Date Written: March 2006


Many real-world markets are competitive only in smalls, taken to mean that price taking applies only to small orders. Starting from this observation, a theory of equilibration is derived where orders are optimal merely in a local sense. Prices are assumed to adjust in the direction of the order imbalance. In the context of financial markets populated with mean-variance optimizing agents, the theory predicts that a security's price will correlate with excess demands in other securities, and the sign of this correlation is the same as that of the covariance of the final payoffs. In the short run, prices tend to a local equilibrium where the risk-aversion weighted endowment portfolio (RAWE) is mean-variance optimal. Relative to the market portfolio, RAWE overweighs securities that are held disproportionally by more risk averse agents; RAWE puts less weight on securities that are held primarily by more risk tolerant agents. Throughout equilibration, portfolio separation is violated generically, and violations are more extreme when payoff covariances are positive. For a variety of patterns of initial allocations (including identical initial holdings), the equity premium is larger at the outset than at (CAPM) equilibrium. All these implications are confirmed in experiments.

Keywords: Asset pricing, experimental economics, equilibration, walrasian equilibrium, portfolio allocation

JEL Classification: G11, G12, D51, C92

Suggested Citation

Bossaerts, Peter L., Equilibration Under Competition in Smalls: Theory and Experimental Evidence (March 2006). EFA 2006 Zurich Meetings. Available at SSRN: https://ssrn.com/abstract=923841 or http://dx.doi.org/10.2139/ssrn.923841

Peter L. Bossaerts (Contact Author)

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Department of Finance
Carlton, Victoria 3010

HOME PAGE: http://bmmlab.org

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