The Beauty Contest and Short‐Term Trading

Abstract

Short-termism need not breed informational price inefficiency even when generating Beauty Contests. We demonstrate this claim in a two-period market with persistent liquidity trading and risk-averse, privately informed, short-term investors and find that prices reflect average expectations about fundamentals and liquidity trading. Informed investors engage in "retrospective" learning to reassess inferences (about fundamentals) made during the trading game's early stages. This behavior introduces strategic complementarities in the use of information and can yield two stable equilibria that can be ranked in terms of liquidity, volatility, and informational efficiency. We derive implications that explain market anomalies as well as empirical regularities.

Information, Coordination, and Market Frictions: An Introduction

“…However, as shown in a recent paper by Cespa and Vives [37], this is only part of the story: when liquidity trading is persistent, prices are also driven by average expectations about liquidity shocks. In this context, there are also typically multiple equilibria, with an extremal high information one and an extremal low information one.…”

“…The model's predictions contrast with those of finite-horizon economies (e.g., He and Wang [68], and Cespa and Vives [36]). These models can also feature multiple equilibria, with some of them unstable (see, e.g., Cespa and Vives [37]). However, in these models, equilibrium multiplicity does not come from the bootstrap nature of expectations in OLG economies with an infinite horizon but rather from the inference dynamics under private information in a finite horizon economy.…”

“…Most papers on this subject provide microfoundations that support the prediction that learning is procyclical. Such pro-cyclicality is then used to explain asymmetric business cycle dynamics, that is, slow recoveries and fast collapses (see, among others, Chalkley and Lee [38], Veldkamp [111], Van Nieuwerburgh and Veldkamp [109], Ordoñez [91]). …”

“…The relevant literature for competitive centralized markets includes Vives [117,118], Wang [127], He and Wang [68], Spiegel [106] and Cespa and Vives [36,37], whereas the one for decentralized markets includes Duffie et al [49,50], and Golosov et al [63], among others.…”

Real Risk-Free Rate, the Central Bank, and Stock Market Bubbles

“…V t occurs in the case of short-lived investors, because their noisy private information incorporates rational higher-order beliefs into the equilibrium. Cespa & Vives (2015) also uses a model of short-lived investors with asymmetric information, and ends to two extreme equilibriums: a high information equilibrium P t = V t with low volatility and high liquidity, and a low information equilibrium P t ! V t with high volatility and low liquidity.…”