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Valapet Badri

This document summarizes a seminar on applying search theory to explain capital market behavior and price dispersion. Search theory, initially used for labor markets, can also be applied to capital markets. Capital and risk are not perfectly mobile due to search frictions like high transaction costs, limited information, and intermediation behaviors. These frictions cause prices to vary across assets and markets. Evidence from equity and fixed income markets supports the effects of search frictions in causing price dispersion, influencing the size and speed of capital flows, and affecting market liquidity.

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Capital Mobility and Asset Pricing Search Based Model A three day Seminar by Prof. Darrell Duffie Princeton University (Oct 2007) Excerpts - Valapet Badri Tried to make this as non-academic as possible Acknowledgement to Darrell Duffie and all the original researcher
Are there Common explanations for ... FI MARKET - Cross-sectional Price Dispersion in Federal funds Muni Bonds Governtment Bonds Equity Market - Price behavior during Fire sale of equities by Mutual fund Listing/Delisting effect on individual stock prices from S&P 500
Search Theory Initial search theory was applied to labor market - conditions when an unemployed would accept an offer.(Stigler 1961, J Mcall 1970) Optimal search for a job depends on Reservation wage (minimum acceptable wage) Risk tolerance and Free flow Job Information availability Time to wait to take an offer Greater variance of wages offered (similar to price dispersion)
Capital Markets So called Law of one price Think in terms of price dispersion In Ideal Market (Job) the law of one price should be attainable It is typically, one for ask and bid price ----------------------------------------------- Applying these concepts to markets to explain capital movement -----------------------------------------------
Market Conditions Capital and risk are not perfectly mobile Imperfect counter party searches Hard to locate assets Trade through intermediation behavior threaten execution delays, hence convey informational benefits and market power to dealers and other providers of immediacy. Time signature of price responses to supply shocks gives an indication of search friction Causes opaqueness and execution delays Supply shifts Vs.demand shifts after a loss
Search based pricing I. Capital Mobility Low premium markets to high premium markets Migration rate is considered Endogenous Limitations - intermediation costs search frictions Intensity of capital flows depends on the premium differential
II. Study of Post catastrophe market conditions Search Friction, intensity of capital flow determines behavior. Other factors Intermediation behavior - dealer efficiency and spreads Variation in liquidity among multiple assets
Search Models Several models proposed based on Probability of Agent interaction in large/Small sample sets Behavior of agents while bargaining given an outside option price Information available on the market and each other motives Dealer efficiency and spreads Boltzman cross- sectional distribution
Evidence in Equity Markets Equity Market - Price Behavior of Individual Stocks - Large Markets Rebalancing of S&P 500 and price effect on the affected stock (no longer exists due to hedge, arb opportunity countered the impact over time) Large "arbitrager" price impacts Fire sale of equity by a large mutual fund
Evidence in Fixed Income Markets FI Markets Considerably lesser transactions compared to Equity - Inherently more susceptible to search friction Search and negotiation are critical Evidence found in Cross-sectional price dispersion Federal funds Muni Bonds Governtment Bonds Price execution improves with access to counter parties and deteriorates with time pressure to trade.

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search_eq_FI_appln

  • 1. Capital Mobility and Asset Pricing Search Based Model A three day Seminar by Prof. Darrell Duffie Princeton University (Oct 2007) Excerpts - Valapet Badri Tried to make this as non-academic as possible Acknowledgement to Darrell Duffie and all the original researcher
  • 2. Are there Common explanations for ... FI MARKET - Cross-sectional Price Dispersion in Federal funds Muni Bonds Governtment Bonds Equity Market - Price behavior during Fire sale of equities by Mutual fund Listing/Delisting effect on individual stock prices from S&P 500
  • 3. Search Theory Initial search theory was applied to labor market - conditions when an unemployed would accept an offer.(Stigler 1961, J Mcall 1970) Optimal search for a job depends on Reservation wage (minimum acceptable wage) Risk tolerance and Free flow Job Information availability Time to wait to take an offer Greater variance of wages offered (similar to price dispersion)
  • 4. Capital Markets So called Law of one price Think in terms of price dispersion In Ideal Market (Job) the law of one price should be attainable It is typically, one for ask and bid price ----------------------------------------------- Applying these concepts to markets to explain capital movement -----------------------------------------------
  • 5. Market Conditions Capital and risk are not perfectly mobile Imperfect counter party searches Hard to locate assets Trade through intermediation behavior threaten execution delays, hence convey informational benefits and market power to dealers and other providers of immediacy. Time signature of price responses to supply shocks gives an indication of search friction Causes opaqueness and execution delays Supply shifts Vs.demand shifts after a loss
  • 6. Search based pricing I. Capital Mobility Low premium markets to high premium markets Migration rate is considered Endogenous Limitations - intermediation costs search frictions Intensity of capital flows depends on the premium differential
  • 7. II. Study of Post catastrophe market conditions Search Friction, intensity of capital flow determines behavior. Other factors Intermediation behavior - dealer efficiency and spreads Variation in liquidity among multiple assets
  • 8. Search Models Several models proposed based on Probability of Agent interaction in large/Small sample sets Behavior of agents while bargaining given an outside option price Information available on the market and each other motives Dealer efficiency and spreads Boltzman cross- sectional distribution
  • 9. Evidence in Equity Markets Equity Market - Price Behavior of Individual Stocks - Large Markets Rebalancing of S&P 500 and price effect on the affected stock (no longer exists due to hedge, arb opportunity countered the impact over time) Large "arbitrager" price impacts Fire sale of equity by a large mutual fund
  • 10. Evidence in Fixed Income Markets FI Markets Considerably lesser transactions compared to Equity - Inherently more susceptible to search friction Search and negotiation are critical Evidence found in Cross-sectional price dispersion Federal funds Muni Bonds Governtment Bonds Price execution improves with access to counter parties and deteriorates with time pressure to trade.