China node

Leader: Ho-Mou Wu

The Chinese Node will be expanded in the future to include serious scholars in China and in the East Asian Area (except Japan) who are interested in the proposed direction of research. It currently consists of three scholars: Ho-Mou Wu (Peking University, Beijing, China); Jianguo Xu (Peking University, Beijing, China); Wen-Chung Guo (National Taipei University, Taipei, Taiwan).

Past research of this group has covered the formalization of the concept of endogenous uncertainty with a focus on its implications for financial markets, including the resultant market volatility, asset price properties and corporate finance issues with diverse beliefs. The thrust of our research breaks away from the rational expectation framework where the agents are assumed to know at each date the map between future exogenous states and future commodity and security prices.

We focus on three aspects of the new direction. Firstly, we continue developing the content of endogenous uncertainty. A particular focus is to make the future prices to be dependent on both future states and future belief structures. The endogenously formed beliefs thus cause the future prices to fluctuate beyond the influence of the future states. Such an additional dimension of uncertainty is called endogenous uncertainty (Kurz and Wu, 1996). Such kind of endogenous uncertainty can also be caused by a complex web of contractual obligations that transmit individual risks and defaults and amplify them into correlated and collective risks an defaults (Chichilnisky and Wu, 2006). The conditions for such endogenous uncertainty include the departure from complete markets (Cass, Chichilnisky and Wu, 1996).

Secondly, we continue exploring the implications of uncoordinated diverse beliefs for market volatility and speculative trading. A particular focus is to demonstrate that the equilibrium prices can fluctuate more than the rational expectation prices when there is endogenous uncertainty with diverse beliefs (Wu and Guo, 2003). Asset price volatility and trading volume are influenced by the extent of belief heterogeneity, resulting a price-volume pattern consistent with empirical observations (Wu and Guo, 2004). It is also shown that an increase in leverage ratio causes higher price volatility under some sufficient conditions, while such result may not hold when the shocks are anticipated (Guo,Wang and Wu, 2011), raising an interesting challenge for further research.

Thirdly, we continue studying asset pricing and corporate finance with diverse beliefs and higher order beliefs. On direction is to follow the insights of Keynes (1936) on beauty contest to allow the agents to have different orders of beliefs. It is demonstrated that price drift and empirically observed patterns of trading volume can be generated with diverse orders of beliefs, with the price pattern distinctly different from that of rational expectations framework. Moreover, the advantages of agents with higher order of beliefs are shown to depend on the primitives of their information precisions (Wu and Qiu, 2010). We also examine the pricing pattern when there is diverse beliefs and the corporate decision including initial public offerings with divergent opinions (Xu, 2007, Chen and Guo,2010), that are also distinct from past work based on rational expectations.

The future research of this group will continue with the three aspects of the new direction as mentioned above. In addition, we will search for a unified understanding of the 2008 financial crisis with our framework of endogenous uncertainty and uncoordinated diverse beliefs. Moreover, we will also study the impacts of the new set of financial regulations on market volatility and proper functioning of the global financial market.