Trading on Sunspots

38 Pages Posted: 5 Jan 2015 Last revised: 16 May 2021

See all articles by Boyan Jovanovic

Boyan Jovanovic

New York University - Department of Economics

Viktor Tsyrennikov

Cornell University - Department of Economics

Date Written: December 2014

Abstract

In a model with multiple Pareto-ranked equilibria we add trade in assets that pay based on the realization of a sunspot. Asset trading restricts the equilibrium set in a way that raises welfare by eliminating equilibria with a high likelihood of disasters. When the probability of a disaster is high enough, the coordination game becomes like a prisoner’s dilemma situation in which the high-output equilibrium disappears because the portfolios that agents choose induce them to produce less. We derive an upper bound on the disaster probability, we derive asset pricing implications including the disaster premium, and we study the effect on stock prices of news shocks to beliefs.

Suggested Citation

Jovanovic, Boyan and Tsyrennikov, Viktor, Trading on Sunspots (December 2014). NBER Working Paper No. w20813, Available at SSRN: https://ssrn.com/abstract=2545211

Boyan Jovanovic (Contact Author)

New York University - Department of Economics ( email )

19 w 4 st.
New York, NY 10012
United States

Viktor Tsyrennikov

Cornell University - Department of Economics ( email )

Ithaca, NY
United States

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