The Behavior of Financial Markets under Rational Expectations

The financial markets have become more and more important in modern society. The behavior of the financial markets, and its impacts on our society, relies crucially on the behavior of market participants, aka the investors of different types. Although descriptions of the financial markets on the macro level have caught great attentions of investors, regulators, and the ordinary people, how the market participants interact with each other in the financial market may provide deeper insights on how and why the financial markets behave. This book tries to supply as much research on the micro level of financial market behavior as possible to the readers. The author has been doing financial research, especially on the micro level, during the past two decades. The academic research on this broad area has undergone a rapid growth, with new results, methods, theories, and even paradigms, emerging and burgeoning almost every year. As a financial researcher in one of China’s top universities, the author has kept monitoring, digesting, and synthesizing the research articles in the area. This book is the outcome of this decades-long routine research work of the author. The book covers the fundamental economic theories of how different investors receive and interpret information. The empirical results of investors behavior are also discussed in depth. The book also shows the basic academic techniques of modeling the investors behavior.

Table of Contents

1 Information
1.1 Rational expectations
1.2 Different opinions
1.3 Information Aggregation and learning
1.4 How do Agents Learn New Information
1.5 Information and pricing
1.6 Further issues of learning and reacting
1.7 Information providers
2 How are Prices Formed?
2.1 The Perspective of Asset Pricing Literature
2.2 Inventory Costs Based Microstructure Models
2.3 Information Based Microstructure Models
2.4 What is Risk?
2.5 Trading mechanism .
2.6 Short selling
2.7 Other Topics in Microstructure
3 Liquidity 17
3.1 Measuring Liquidity
3.2 Volume .
3.3 Determinants of Liquidity
3.4 Market’s and Liquidity Providers’ Conditions and Liquidity
3.5 The Effect of Liquidity on the Firm’s Well Beings
3.6 Who is Providing Liquidity
4 Limit Orders
4.1 The Models of Limit Orders
4.2 Investor’s Choice of Limit versus Market Orders
4.3 Limit Order Revisions and Aggressiveness
4.4 Limit Order Patterns .
5 Depicting investors
5.1 Theory Based Investor Taxonomy
5.2 Identity Based Investor Taxonomy
5.3 Investor sophistication
5.4 Herding and correlated trading .
5.5 Trading behavior
6 Mutual Funds
6.1 Fund Performance and Fund Manager Skills
6.2 Funds herding .
6.3 Incentives and the risk shifting
6.4 Fund Flow and Investor’s Preferences
6.5 Fund Fees
6.6 Governance of Funds
7 Prices of IPO and SEO 46
7.1 Why and When to Issue New Equities
7.2 Choice of Issue Types .
7.3 New Issuance Pricing . .
7.4 Trading around IPO and SEO
7.5 Market Reaction and Long Term Performance
8 Behavioral Explanation 51
8.1 General discussion on the behavioral explanation .
8.2 Disposition effect and prospect theory
8.3 Overconfidence and Over-reaction
8.4 Awareness, familiarity, and Attention .
8.5 Law of small numbers
8.6 Rational structural uncertainty models
9 Modeling economic behavior
9.1 Nash Equilibrium
9.2 Bayesian Games
9.3 Utility maximization models
10 Mathematical Techniques for Economic Modeling 64
10.1 Difference Equations
10.2 Differential Equations
10.3 Fixed Point
10.4 Static Optimization
10.5 Duality
11 Empirical Methodology
11.1 Regressions
11.2 Non-Regression Methods
11.3 Endogeneity
11.4 Measurements
Bibliography