L4

We extend Kyle's (1985) model of insider trading to the case where liquidity provided

by noise traders follows a general stochastic process. Even though the level of noise

trading volatility is observable, in equilibrium, measured price impact is stochastic.

If noise trading volatility is mean-reverting, then the equilibrium price follows a

multivariate stochastic volatility `bridge' process. More private information is revealed

when volatility is higher. This is because insiders choose to optimally wait to trade

more aggressively when noise trading volatility is higher. In equilibrium, market makers

anticipate this, and adjust prices accordingly. In time series, insiders trade more

aggressively, when measured price impact is lower. Therefore, aggregate execution costs

to uninformed traders can be higher when price impact is lower

We study optimal portfolio strategies in a market

where the drift is driven by an unobserved Markov chain. Information on

the state of this chain is obtained from stock prices and from expert

opinions in the form of signals at random discrete time points. We use

stochastic filtering to transform the original problem into an

optimization problem under full information where the state variable is

the filter for the Markov chain. This problem is studied with dynamic

programming techniques and with regularization arguments. Finally we

discuss a number of numerical experiments

We consider over-the-counter (OTC) transactions with bilateral default risk, and study the optimal design of the Credit Support Annex (CSA). In a setting where agents have access to a trading technology, default penalties and collateral costs arise endogenously as a result of foregone investment opportunities. We show how the optimal CSA trades off the costs of the collateralization procedure against the reduction in exposure to counterparty risk and expected default losses. The results are used to provide insights on the drivers of different collateral rules, including hedging motives, re-hypothecation of collateral, and close-out conventions. We show that standardized collateral rules can have a detrimental impact on risk sharing, which should be taken into account when assessing the merits of standardized vs. bespoke CSAs in non-centrally cleared OTC instruments. This is joint work with D. Bauer and L.R. Sotomayor (GSU).

We analyse the impact of market makers' risk aversion on the equilibrium in a speculative market consisting of a risk neutral informed trader and noise traders. The unwillingness of market makers to bear risk causes the informed trader to absorb large shocks in their inventories. The informed trader's optimal strategy is to drive the market price to its fundamental value while disguising her trades as the ones of an uninformed strategic trader. This results in a mean reverting demand, price reversal, and systematic changes in the market depth. We also find that an increase in risk aversion leads to lower market depth, less efficient prices, stronger price reversal and slower convergence to fundamental value. The endogenous value of private information, however, is non-monotonic in risk aversion. We will mainly concentrate on the case when the private signal of the informed is static. If time permits, the implications of a dynamic signal will be discussed as well.

Based on a joint work with Albina Danilova.

The performance of the shares of a closed end bond fund is based on the returns of an underlying portfolio of bonds. The returns on closed end bond funds are typically higher than those of comparable open ended bond funds and this result is attributed to the use of leverage by closed end bond funds. This talk develops a simple model to assess the impact of leverage on the expected return and riskiness of a closed end bond fund. We illustrate the model with some examples