“Beauty Contests, Risk Shifting, and Bubbles” by Henry Cao
Cheung Kong Graduate School
In a beauty contest model, the current stock price depends on investors' beliefs of intermediary prices and the final payoff. We show that investors who perceive the lowest risk in one period tend to bear more of the financial risk in that period. As investors who perceive the lowest risk can vary across different periods, the overall perception of risk is reduced in an economy with dynamic trading. The reduction of risk premium causes the stock price to be higher than its fundamental value, resulting in a bubble. If investors with lower risk perceptions of the intermediary prices are more optimistic about the intermediary prices, then the bubble is further enlarged. On the other hand, if investors with lower risk perceptions of the intermediary prices are more pessimistic about the intermediary prices, then a bubble can be reduced or even become negative. Reduction of perceived overall risk due to dynamic trading also increases market liquidity of the stock. Contrary to the conventional wisdom, we show that stock trading volume is also affected by the differences of opinion in future trading periods, due to the demands to hedge future trading opportunities. We extend the setting to incorporate multiple stocks and show that dynamic trading and heterogeneous beliefs about risk lead to a lower risk premium on the market portfolio.