Daniel Andrei

Information percolation, momentum and reversal

We propose a joint theory of time-series momentum and reversal based on a rational-expectations model. We show that a necessary condition for momentum to arise in this framework is that information flows at an increasing rate. We focus on word-of-mouth communication as a mechanism that enforces this condition and generates short-term momentum and long-term reversal. Investors with heterogeneous trading strategies—contrarian and momentum traders—coexist in the marketplace. Although a significant proportion of investors are momentum traders, momentum is not completely eliminated. Word-of-mouth communication spreads rumors and generates price run-ups and reversals. Our theoretical predictions are in line with empirical findings.

Information Percolation Driving Volatility

Sudden big price changes are followed by periods of high and persistent volatility. I develop a tractable dynamic rational expectations model consistent with this observation. An infinity of agents possess dispersed information about future dividends and trade in centralized markets. Information is processed, transmitted, and aggregated in two ways: (i) agents meet randomly and exchange information through word-of-mouth communication, and (ii) the price aggregates information through the trading process. Both mechanisms operate simultaneously to generate high and persistent volatility. The resulting information flow drives both returns and volume. The short-term asset, defined as the claim to immediate future dividends, becomes more volatile. The pronounced heterogeneity in investors’ information endowments induces patterns of trade consistent with empirical findings. These results serve as a road sign indicating the central role played by word-of-mouth communication in financial markets.

Information Percolation in Centralized Markets

We propose a joint theory of time-series momentum and reversal based on a rational-expectations model. We show that a necessary condition for momentum to arise in this framework is that information flows at an increasing rate. We focus on word-of-mouth communication as a mechanism that enforces this condition and generates short-term momentum and long-term reversal. Investors with heterogeneous trading strategies — contrarian and momentum traders — coexist in the marketplace. Although a significant proportion of investors are momentum traders, momentum is not completely eliminated. Word-of-mouth communication spreads rumors and generates price run-ups and reversals. Our theoretical predictions are in line with empirical findings.

Schumpeterian Competition and Financial Markets

While previous work has focused on the rewards of creative destruction, this paper explores how Schumpeterian competition affects risk. We analyze a game in a Lucas endowment economy in which non-cooperative agents compete for the rents of a consumption stream and bear the risk imposed by creative destruction. Compared to first best, the quest for oligopoly rents leads to over-investment in uncertain projects, which magnifies both the volatility of future consumption and the uncertainty about the expected growth rate of the economy. Within the context of our model, this results in spikes in the price- dividend ratio. If competition for rents is sufficiently intense, the elevated price-dividend ratio predicts negative future expected excess returns, which is consistent with the patterns typically observed during periods of marked technological change.

Asset Pricing with Disagreement and Uncertainty about the Length of Business Cycles

We study an economy with incomplete information in which two agents are uncertain and disagree about the length of business cycles. That is, the agents do not question whether the economy is growing or not, but instead continuously estimate how long economic cycles will last — i.e., they learn about the persistence of fundamentals. Learning about persistence generates high and persistent stock return volatility mostly during recessions, but also (to a smaller extent) during economic booms. Disagreement among agents fluctuates and earns a risk premium. A clear risk-return tradeoff appears only when conditioning on the sign and magnitude of disagreement. We confirm these predictions empirically.

Asset Pricing with Persistence Risk

Persistence risk is an endogenous source of risk that arises when a rational agent learns about the length of business cycles. Persistence risk is positive during recessions and negative during expansions. This asymmetry, which solely results from learning about persistence, causes expected returns, return volatility, and the price of risk to rise during recessions. Persistence risk predicts future excess returns, particularly at 3- to 7-year horizons. Its predictability is strongest around business-cycle peaks and troughs. We confirm the models predictions in the data and provide evidence that persistence risk is priced in financial markets.