Essays on Asset Pricing

Abstract

This dissertation consists of three essays. The first essay is titled "Speculative Dynamics I: Imperfect Competition and the Implications for High Frequency Trading". In this essay, I analyze the nature of imperfect competition among informed traders who continuously generate and exploit private information about a risky asset's liquidation value which follows either a mean reverting process or random walk. I find the following results: (i) The combined trading of multiple informed traders is much more aggressive than the monopolistic trader in Chau and Vayanos (2008). (ii) The equilibrium price is even more revealing of the informed trader's private information. (iii) Market depth improves as the number of informed traders increases. (iv) In the limit of continuous trading, market is strong form efficient while aggregate profits of the informed traders remain bounded away from zero, in sharp contrast to the corresponding results in Holden and Subrahmanyam (1992), and Foster and Viswanathan (1993). (vi) Informed traders' inventories follows a Brownian motion, therefore enabling them to contribute significantly to total trading volume and price variance. These results shed light on empirical findings regarding high frequency traders by helping explain why they remain protable despite aggressive competition with each other, why their trading volume is very high, to what extent they improve efficiency, and through what mechanism they improve liquidity.

The second essay is titled "Speculative Dynamics II: Asymmetric Informed Traders". In this essay, I study the strategic interaction between hierarchical duopolistic informed traders who continuously generate and exploit private information about a risky asset's liquidation value, which follows either a mean reverting process or random walk. I find the following results: (i) Both traders duopolize the private information they both observe and the more informed trader monopolizes the additional exclusive private information. (ii) The common private information is incorporated into prices more efficiently than the monopolistic private information. (iii) In the limit of continuous trading, both traders' inventories based on their shared information follow Brownian motions. (iv) The trader with less superior information has more contribution to the trading volume and price volatility when the frequency of trading is sufficiently high. (v) As trading becomes more frequent, the less informed trader's expected profits may fall but converges to a strictly positive constant in the limit.

The third essay is titled "Real Options and Product Differentiation". In this essay, I develop a continuous time real investment model in an oligopoly industry where the products are heterogeneous. Although the heterogeneous products assumption can lower each firm's incentive to exercise the growth options prematurely, the preemption strategy is still profitable.