Asset Pricing Implications of Social Networks ∗

Recent empirical studies suggest that social networks, according to which communication takes place, have a significant impact on traders ’ financial decisions. Motivated by this evidence, we propose an asset pricing model in which agents communicate information according to a social network. In the proposed model, agents initially have imperfect and diverse information about the asset payoff structure. Via communication, agents learn, i.e. gain information, about the asset payoff structure from others in the economy. The social network indicates whom each agent learns from. The social network is exogenous and can be considered to represent geographical proximities as well as social relationships (such as friendships and acquaintanceships). The model generates several novel implications. First, we prove that social influence is a determinant in asset pricing, where one’s influence is determined by her connections in the social network. Then we show that proximities between agents in the social network affect agents ’ asset demand correlations: demands of agents from the same tight-knit social cluster exhibit higher correlations compared to demands of those from disjoint social clusters. Impact of social networks on asset price volatility is also explored. We demonstrate that learning in social networks may account for the observed high volatility ratio of price to fundamentals in the stock markets. Finally, we investigate how different specifications of social networks affect agents ’ assessments of the asset payoff structure. To that end, we introduce the notions of informational dominance and informational efficiency, which essentially rank social networks according to the precision of information they generate for agents in the economy. We provide partial characterizations of informationally dominant and informationally efficient social networks

Amplification and Asymmetry in Crashes and Frenzies

We often observe disproportionate reactions to tangible information in large stock price movements. Moreover these movements feature an asymmetry: the number of crashes is more than that of frenzies in the S&P 500 index. This paper offers an explanation for these two characteristics of large movements in which hedging (portfolio insurance) causes amplified price reactions to news and liquidity shocks as well as an asymmetry biased towards crashes. Risk aversion of traders is shown to be essential for the asymmetry of price movements. Also, we show that differential information enhances both amplification and asymmetry delivered by hedging.

Hype and Dump Manipulation.

This paper introduces signaling in a standard market microstructure model so as to explore the economic circumstances under which hype and dump manipulation can be an equilibrium outcome. We consider a discrete time, multi-period model with stages of signaling and asset trading. A single informed trader contemplates whether or not to spread a (possibly dishonest) rumor on the asset payoff among uninformed traders. Dishonest rumor-mongering is costly due to regulatory enforcement, and the uninformed traders who access the rumor can be sophisticated or naive. The sophisticated traders correctly anticipate the relationship between the rumor and the asset payoff, whereas the naive ones take the rumor at its face value as if it truthfully reveals the asset payoff. The presence of sophisticated traders puts the informed trader off from rumor-mongering, because sophisticates fully infer the asset payoff from the rumor, reducing the informational rents enjoyed by the informed trader. Nevertheless we show that it can be optimal for an informed trader to create false hype among uninformed traders provided that there is at least one naive trader in the market and the cost of dishonest rumor-mongering is not too low. The false hype allows the informed trader to sell at an inflated price or buy at a deflated one. Intense regulatory enforcement, which makes dishonest rumor-mongering very costly, may not necessarily curb hype and dump schemes. Market depth and trading volume rise with “hype and dump” while market efficiency decreases

Price, trade size, and information revelation in multi-period securities markets

We study price formation in securities markets, using the sequential trade framework of Glosten and Milgrom [7]. This paper makes one basic methodological advance over previous research on sequential securities trading: we allow traders to choose from n trade sizes in a multi-period market, where n can be arbitrarily large. We examine,how trade size multiplicity affects the intertemporal dynamics,of trading strategies, bid-ask spreads, and information revelation. We show that price impact, as a function of trade size, is increasing and exhibits (discrete) concavity

Price, Trade Size, and Information Revelation in Multi-Period Securities Markets

We study price formation in securities markets, using the sequential trade framework of Glosten and Milgrom. This paper makes one basic methodological advance over previous research on sequential securities trading: we allow traders to choose from n trade sizes in a multi-period market, where n can be arbitrarily large. We examine how trade size multiplicity affects the intertemporal dynamics of trading strategies, bid-ask spreads, and information revelation. We show that price impact, as a function of trade size, is increasing and exhibits (discrete) concavity.

Communication Dilemma in Speculative Markets

We study voluntary information exchange widely observed among traders in financial markets. In the context of a standard market microstructure model, based on Kyle (1984, 1985), we show that disparately informed traders are better off by exchanging information provided that they are risk averse and the market is opaque. For some parameter values, the equilibrium yields a prisoners' dilemma result in which traders hoard information even though it is beneficial for them to exchange. In the presence of interpersonal costs, which penalize those who hoard information when others disclose, information exchange can be sustained as an equilibrium outcome. Repeated interactions can also sustain, an equilibrium, information exchange.