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Asset pricing when trading is for entertainment

Asset pricing when trading is for entertainment High levels of turnover in financial markets are consistent with the notion that trading, like gambling, yields direct utility to some agents. The purpose of this paper is to show that the presence of these agents attenuates covariance risk pricing and volatility, and implies a negative relation between volume and future returns. Since psychological literature indicates that the desirability of a gamble arises from the ex ante volatility of the outcome, the authors propose that agents derive greater utility from trading more volatile stocks. These stocks earn lower average returns in equilibrium, although the risk premium on the market portfolio is positive. The authors then consider a dynamic setting where agents’ utility from trading increases when they make positive profits in earlier rounds (e.g. due to an endowment effect). This leads to “bubbles,” i.e. disproportionate jumps in asset returns as a function of past prices, higher volume in up markets relative to down markets, as well as a leverage effect, wherein down markets are followed by higher volatility than up markets.Design/methodology/approachAnalytical.FindingsThe presence of gamblers attenuates covariance risk pricing and volatility, and implies a negative relation between volume and future returns. If gamblers prefer more volatile stocks, these stocks earn lower average returns in equilibrium. If agents’ utility from trading increases when they make positive profits in earlier rounds (e.g. to an endowment effect), this leads to higher volume and lower volatility in up markets relative to down markets.Originality/valueNo paper has previously modeled agents who derive direct utility from trading. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Behavioral Finance Emerald Publishing

Asset pricing when trading is for entertainment

Luo, Jiang; Subrahmanyam, Avanidhar
Review of Behavioral Finance , Volume 11 (2): 45 – Jun 24, 2019
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References (83)

Publisher
Emerald Publishing
Copyright
© Emerald Publishing Limited
ISSN
1940-5979
DOI
10.1108/rbf-04-2018-0042
Publisher site
See Article on Publisher Site

Abstract

High levels of turnover in financial markets are consistent with the notion that trading, like gambling, yields direct utility to some agents. The purpose of this paper is to show that the presence of these agents attenuates covariance risk pricing and volatility, and implies a negative relation between volume and future returns. Since psychological literature indicates that the desirability of a gamble arises from the ex ante volatility of the outcome, the authors propose that agents derive greater utility from trading more volatile stocks. These stocks earn lower average returns in equilibrium, although the risk premium on the market portfolio is positive. The authors then consider a dynamic setting where agents’ utility from trading increases when they make positive profits in earlier rounds (e.g. due to an endowment effect). This leads to “bubbles,” i.e. disproportionate jumps in asset returns as a function of past prices, higher volume in up markets relative to down markets, as well as a leverage effect, wherein down markets are followed by higher volatility than up markets.Design/methodology/approachAnalytical.FindingsThe presence of gamblers attenuates covariance risk pricing and volatility, and implies a negative relation between volume and future returns. If gamblers prefer more volatile stocks, these stocks earn lower average returns in equilibrium. If agents’ utility from trading increases when they make positive profits in earlier rounds (e.g. to an endowment effect), this leads to higher volume and lower volatility in up markets relative to down markets.Originality/valueNo paper has previously modeled agents who derive direct utility from trading.

Journal

Review of Behavioral Finance – Emerald Publishing

Published: Jun 24, 2019

Keywords: Finance; Volume; Behavioural

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