At first sight, the two papers in this section seem unrelated. The one by John Geanakoplos is about the role of collateral in explaining liquidity crises and crashes. Andrew Lo and Jiang Wiang's paper is concerned with a theoretical and empirical analysis of trading volume. However, on closer inspection, they have important interrelationships and provide an interesting contrast. They both trace their intellectual roots back to the Arrow–Debreu model, yet they represent two very different approaches to financial economics, both of which are widely used.
The papers investigate deviations from the standard perfect-markets assumption. Frictions are incorporated in a different way, though. In the Geanakoplos paper, the problem is preventing default, and collateral is the way this is achieved. In the Lo and Wang paper, there are asymmetric information and fixed transaction costs. What is more important is that the motivations for trade are quite different. In the Geanakoplos paper, it is differences in beliefs; in the Lo and Wang paper, it is different shocks to nonfinancial income. Both of these assumptions are crucial to the results the authors obtain. They represent quite different traditions.
The Geanakoplos paper is a mainstream general equilibrium paper. In the Arrow–Debreu model, the possibility of differences in preferences is an important component of the model. Because beliefs are embedded in preferences, allowing different beliefs is a standard assumption.
In finance, and in particular in asset pricing, allowing different beliefs is currently viewed as a nonstandard assumption.
One of the most fundamental notions of economics is the determination of prices through the interaction of supply and demand. The remarkable amount of information contained in equilibrium prices has been the subject of countless studies, both theoretical and empirical, and with respect to financial securities, several distinct literatures devoted solely to prices have developed. Indeed, one of the most well-developed and most highly cited strands of modern economics is the asset-pricing literature.
However, the intersection of supply and demand determines not only equilibrium prices but also equilibrium quantities, yet quantities have received far less attention, especially in the asset-pricing literature (is there a parallel asset-quantities literature?). One explanation for this asymmetry is the fact that, for most individual investors, financial markets have traditionally been considered close to perfectly competitive, so that the size of a typical investment has little impact on prices. For such scale-free investment opportunities, quantities are largely irrelevant and returns become the basic objects of study, not prices. But for large investors such as institutional investors, the securities markets are not perfectly competitive, at least not in the short run. Moreover, when investors possess private information – about price movements, their own trading intentions, and other market factors – perfect competition is even less likely to hold.
For example, if a large pension fund were to liquidate a substantial position in one security, that security's price would drop precipitously if the liquidation were attempted through a single sell-order, yielding a significant loss in the value of the security to be sold.
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