Hongjun Yan

Natural Selection in Financial Markets: Does it Work?

Can investors with incorrect beliefs survive in financial markets and have a significant impact on asset prices? My paper addresses this issue by analyzing a dynamic general equilibrium model where some investors have rational expectations, whereas others have incorrect beliefs concerning the mean growth rate of the economy. The main result is that an investor can survive if and only if he has the lowest survival index, which is a function of his belief accuracy, patience parameter, and relative risk aversion coefficient. If preferences are held constant across all investors, then those with incorrect beliefs cannot survive in the limit, although calibrations reveal that the selection process is excessively slow. However, if preferences vary across investors, even slightly, it becomes possible for an irrational investor to dominate the market even if his beliefs persistently and substantially deviate from the truth.

Anticipated and Repeated Shocks in Liquid Markets

We show that Treasury security prices in the secondary market decrease significantly before subsequent auctions and recover shortly after. This price pattern implies a large issuance cost for the Treasury Department, which is estimated to be between 9 and 18 basis points of the auction size. For example, this cost amounts to over half a billion dollars for issuing Treasury notes alone in 2007. Our results appear to be consistent with the hypothesis of primary dealers’ limited risk-bearing capacity and the imperfect capital mobility of end investors in the Treasury market (e.g., federal agencies, sovereign wealth funds, pension funds, and etc.), highlighting the important role of capital mobility even in the most liquid financial markets.