Momentum and Reversal in a Financial Market with Persistent
Heterogeneity, with Giulio Bottazzi and Daniele Giachini (February 2018)
This paper investigates whether short-term momentum and long-term reversal may emerge from the wealth reallocation process taking place in speculative markets. We assume that there are two classes of investors who trade long-lived assets by holding constantly rebalanced portfolios based on their beliefs. Provided beliefs, and thus portfolios, are sufficiently diversified, all investors survive in the long-run and, due to waves of mispricing, the resulting equilibrium returns exhibit long-term reversal. If, moreover, asset dividends are positively correlated, investors’ profitable trades become positively correlated too, thus generating short-term momentum in equilibrium returns. We use the model to replicate the performance of the Winners and Losers portfolios highlighted by the empirical literature and to provide insights on how to improve upon them. Finally, we show that dividend positive autocorrelation is positively related to momentum and negatively related to reversal while diversity of beliefs is positively related to both momentum and reversal. (submitted)
The Wisdom of the Crowd in Dynamic Economies, with Filippo Massari (September 2017) Slides
The Wisdom of the Crowd applied to financial markets asserts that prices, an average of agents' beliefs, are more accurate than individual beliefs. However, a market selection argument implies that prices eventually reflect only the beliefs of the most accurate agent. In this paper, we show how to reconcile these alternative points of view. In markets in which agents naively learn from equilibrium prices, a dynamic Wisdom of the Crowd holds. Market participation increases agents' accuracy, and equilibrium prices are more accurate than the most accurate agent. If we replace naive learning with Bayes' rule, this positive result disappears.
Drift criteria for persistence of discrete stochastic processes on the line, with Giulio Bottazzi (December 2015)
We provide sufficient conditions for the persistence or transience of stochastic processes on the line based on the sign of the conditional drift.
Our findings extend previous results in the literature to the large class of discrete time processes with bounded increments.
Work in Progress
Risk pooling and leverage cycles in a
dynamic economy with fragmented
financial markets, with Andrea Modena and Loriana Pelizzon
In this paper we investigate the side effects of risk pooling activity of an aggregate financial sector upon the dynamics of a productive
economy. We build a general equilibrium model with heterogeneous agent and fragmented financial markets. Due to exposure to idiosyncratic risk
factors and partial market incompleteness, heterogeneous entrepreneurs are willing to mitigate the risk of their portfolio by purchasing
riskless claims from the financial sector. While the former has no leverage, the latter leverage its balance-sheet by shorting a risk free bond. The risk pooling role of the financial sector generates cycles with real
spillover effects of which financial sector relative capitalisation is the core driver. This structure stems, at the equilibrium, a
non-trivial ergodic distribution of wealth and a dynamics through which the system may float for long periods far from its steady state. We focus then on welfare effects of static
leverage constraints upon the financial sector. When the financial sector is undercapitalised, the share of pooled idiosyncratic risk is
suboptimal. As long as the leverage constraint binds, a reduced volatility of relative wealth share (state diffusion) is associated with a diminished
speed of recovery of the financial sector (state drift). In the long run, tighter limits upon leverage generate an overweighted left tail of
relative wealth distribution due to a sticky transition through the constrained region of the state space. Moreover, we find out that the
financial sector’s expected welfare is monotonically decreasing in leverage constraints, whereas the same does not hold for entrepreneurs.
On the Interplay Between Norms and Strategic Environments, with Sebastiano Della Lena
This paper investigates the intergenerational dynamics of norms in a heterogeneous
population divided into two cultural groups. In their adult life, agents are randomly
matched in pairs to play a 2 × 2 strategic game. Norms are preferences over actions and
thus interact with material payoffs, and as such, they have an effect on Nash Equilibria. In turn, games influence norms because actions played in equilibrium reinforce the
corresponding norm. At the end of their life, parents myopically transmit their norms to offspring that actively choose their own norm taking
into account both the inherited norms and the norms of their peers. The socialization level depends on how much actions
conform to the population mean. In our model, stable norms emerge as a steady state outcome of the joint dynamics of norms, actions, and
socialization levels. We exploit this model to study of cultural convergence and the
arising of oppositional cultures. For all strategic environments, both convergence and
divergence of norms can arise as stable outcomes. Moreover, we find that complement or
substitution environments can produce different equilibria, with partial convergence or
divergence. At the end, we provide indications for policy intervention, showing that there exist cases where simple policies can
induce very different norms and cases where more drastic interventions are needed.