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Rational asset pricing implications from realistic trading frictions

Zigrand, Jean-Pierre (2002) Rational asset pricing implications from realistic trading frictions. Discussion paper, 414. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

We study a simple rational expectations (RE) model whose asset pricing implications address some of the short-run mispricings, informational inefficiencies, and overreactions observed in real markets, without a need to resort to behavioral assumptions. We accomplish this by relying on the plausible joint frictions of immediacy risk (excution risk) and asset-specific orders (the demand function for asset a cannot be made contingent on the price of any asset other than a). These frictions induce allocational and informational inefficiencies akin to the ones observed in reality. At the closed-form RE Equilibrium it is shown that arbitrage opportunities occur which could not have occured in a standard model. A certain and precise degree of informativeness of prices to the traders is lost because the decision making process becomes endogenously segmented and decentralized within the same decision making entity (distinct "trading desks"). It is shown that, compared to the frictionless benchmark case, volatility is affected at a RE Equlibrium, and that asset prices are likely to overreact to news. Interestingly, the coordination problem arising from limited communication, even though dramatically changing demand functions, does not lead to welfare losses.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2002 The Author
Library of Congress subject classification: H Social Sciences > HF Commerce
H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: G - Financial Economics > G1 - General Financial Markets > G12 - Asset Pricing; Trading volume; Bond Interest Rates
G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies
G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 414
Date Deposited: 20 Aug 2009 10:27
URL: http://eprints.lse.ac.uk/24933/

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