Friday, July 1, 2011

DUMAS Bernard, LYASOFF Andrew
INSEAD Working Paper 2011/76/FIN

We develop a method that allows one to compute incomplete-market equilibria routinely for Markovian equilibria (when they exist). The main difficulty that we overcome arises from the set of state variables. There are, of course, exogenous state variables driving the economy but, in an incomplete market, there are also endogenous state variables, which introduce path dependence. We write on an event tree the system of all first-order conditions of all times and states and solve recursively for state prices, which are dual variables. We illustrate this “dual” method and show its many practical advantages by means of several examples.

DUMAS Bernard, LEWIS Karen K., OSAMBELA Emilio
INSEAD Working Paper 2011/77/FIN

We develop an international financial market model in which domestic and foreign residents differ in their beliefs about the information contained in economic signals. Similar to models of asymmetric information, we consider how informational advantages by domestic investors about local output impacts equity markets. In contrast to these models, however, all information is publicly available, but domestic investors are better equipped to understand the information in local news. We show that our model can help explain four standard international pricing anomalies: (i) home equity preference; (ii) the co-movement of returns and international capital flows; (iii) the dependence of firm returns on local and foreign factors; and (iv) abnormal returns around foreign firm cross-listing in the local market.