Hui Ou-Yang

Estimation of Continuous-Time Models with an Application to Equity Volatility Dynamics

The treatment of this article renders closed-form density approximation feasible for univariate continuous-time models. Implementation methodology depends directly on the parametric-form of the drift and the diffusion of the primitive process and not on its transformation to a unit-variance process. Offering methodological convenience, the approximation method relies on numerically evaluating one-dimensional integrals and circumvents existing dependence on intractable multidimensional integrals. Density-based inferences can now be drawn for a broader set of models of equity volatility. Our empirical results provide insights on crucial outstanding issues related to the rank-ordering of continuous-time stochastic volatility models, the absence/presence of nonlinearities in the drift function of equity volatility, and the desirability of pursuing more flexible diffusion function specifications.

Prospect Theory and Liquidation Decisions

We solve a liquidation problem for an agent with preferences consistent with the prospect theory of Kahneman and Tversky (1978). We find that the agent is willing to hold a risky project with a relatively inferior Sharpe ratio if the project is currently making losses, and intends to liquidate it when it breaks even. On the other hand, the agent may liquidate a project with a relatively superior Sharpe ratio if its current profits rise or drop to the break-even point. Our results capture the spirit of the disposition effect and the break-even effect documented in empirical and experimental studies.

Incentives and performance in the presence of wealth effects and endogenous risk

Abstract Two of the most widely tested predictions of agency theory are that there exists a negative association between an agents pay-performance sensitivity (PPS) and the risk of output, and that PPS enhances performance. Empirical evidence has been mixed. This paper proposes a new utility function and develops a model that introduces a “wealth effect” and also allows the agent to control the (idiosyncratic) risk of output. When risk is endogenous, the paper shows that the two predictions may not hold.

A Model of Portfolio Delegation and Strategic Trading

This article endogenizes information acquisition and portfolio delegation in a one-period strategic trading model. We find that, when the informed portfolio manager is relatively risk tolerant (averse), price informativeness increases (decreases) with the amount of noise trading. When noise trading is endogenized, the linear equilibrium in the traditional literature breaks down under a wide range of parameter values. In contrast, a linear equilibrium always exists in our model. In a conventional portfolio delegation model under a competitive partial equilibrium, the managers effort of acquiring information is independent of a linear incentive contract. In our strategic trading model, however, a higher-powered linear contract induces the manager to exert more effort for information acquisition. The Author 2011. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

The Power Law Characteristics of Stock Price Jump Intervals: An Empirical and Computational Experimental Study

For the first time, the power law characteristics of stock price jump intervals have been empirically found generally in stock markets. The classical jump-diffusion model is described as the jump-diffusion model with power law (JDMPL). An artificial stock market (ASM) is designed in which an agent’s investment strategies, risk appetite, learning ability, adaptability, and dynamic changes are considered to create a dynamically changing environment. An analysis of these data packets from the ASM simulation indicates that, with the learning mechanism, the ASM reflects the kurtosis, fat-tailed distribution characteristics commonly observed in real markets. Data packets obtained from simulating the ASM for 5010 periods are incorporated into a regression analysis. Analysis results indicate that the JDMPL effectively characterizes the stock price jumps in the market. The results also support the hypothesis that the time interval of stock price jumps is consistent with the power law and indicate that the diversity and dynamic changes of agents’ investment strategies are the reasons for the discontinuity in the changes of stock prices.

Risk Premiums, Liquidities, and Bubbles under Heterogeneous Beliefs

We develop a model in which investors have heterogeneous beliefs about both the mean and the risk of future signals and the final stock payoff. As investors who perceive the lowest risk vary across different periods, the overall perception of the market risk is reduced in an economy with dynamic trading, always reducing risk premium and increasing market liquidity. Bubbles can arise without the short-sales constraint. We show that the more frequently investors trade in the future, the more liquid the market today, which provides potential explanations for a number of empirical findings.

Negative Bubbles Under Short-Sales Constraints and Heterogeneous Beliefs

In a dynamic trading model, investors with heterogeneous beliefs have an option to sell the stock now and buy it back later. Due to this repurchase option and the risk aversion of investors, it is possible for the stock price to be lower than the lowest valuation among investors even when the short-sales constraint is binding. This result contrasts that of Harrison and Kreps (1978) in which due to a resale option and risk neutrality, a bubble always arises. We also demonstrate that in a static model, there exists neither a bubble nor a negative bubble.

Informationally Efficient Markets in Grossman and Stiglitz (1980)

We derive an equilibrium price that converges to be strong-form informationally efficient in the original Grossman-Stiglitz model (1980). Specifically, we show that when the private signal converges to be perfect or traders converge to be risk neutral, there exists a unique overall equilibrium for any finite information costs in which the price tends to be strong-form efficient. We further find that when the price tends to be fully revealing, informed and uninformed traders have almost homogeneous beliefs about the stock payoff, but there are still significant trades between them. We thus provide an economically meaningful resolution to the Grossman-Stiglitz paradox.

Speculative Financial Innovation

We analyze how speculative financial innovation affects stock prices, option prices, risk premium, market liquidity, and investor welfare in an economy with heterogeneous beliefs. When investors disagree about the covariance of the newly introduced stocks with the original stocks, we show that financial innovation reduces the variance covariance matrix of the representative investor, which in turn decreases the risk premium of the market portfolio. When investors disagree on the expected payoff of the new stocks, the representative investors expected payoff of the existing stocks will also change due to hedging demands among investors, which causes the stock prices to change. The reduction in the representative investors variance covariance matrix of the existing stocks also results in the implied volatility in options prices to drop. The net effect on option prices is ambiguous as financial innovation also affects the prices of the original stocks. Financial innovation further causes the market liquidity to increase as prices will be less sensitive to supply shocks due to reduced variance covariance matrix of the representative investor. Finally, we show that financial innovation could make all investors better off under their own beliefs but worse off under the true beliefs.