Alp Simsek

Research in Progress

"Speculation and Risk Sharing with New Financial Assets"

Financial innovation has been suggested to have contributed to the recent financial crisis by making the financial markets less stable. This hypothesis runs counter to the traditional view of financial innovation, which holds that new financial assets increase the risk sharing and diversification opportunities among market participants. In this paper, I emphasize that speculation based on belief heterogeneity provides one mechanism by which new assets lead to greater risks, and I theoretically evaluate this mechanism against the traditional view of financial innovation. I consider a standard risk sharing model in which traders have CARA preferences, and endowments and asset returns are normally distributed. New assets provide risk sharing opportunities but they are also subject to speculation as traders have heterogeneous priors about returns. I define the average consumption variance as a measure of risk for this economy and I decompose it into two components: an uninsurable component, defined as the average variance that would obtain if there were no belief heterogeneity, and a speculative component, defined as the residual amount of variance that results from speculative trades based on belief heterogeneity. New assets always decrease the uninsurable component of variance because they increase the possibilities for risk sharing. I show that new assets also always increase the speculative component of variance, because they increase the possibilities for speculative trading. The net effect of new assets on average variance is ambiguous and depends on the relative strengths of the risk sharing and the speculative trading motives. Speculation generated by new assets is amplified through the hedge-more/bet-more effect: traders take speculative positions on new assets which they then hedge by taking complementary positions on existing assets, which in turn enables them to place larger speculative positions and, ultimately, take on greater risks. Using the hedge-more/bet-more effect, I show that new assets lead to a greater increase in the speculative component of variance when they are introduced into a more complete asset market, or when they are more correlated with existing assets (e.g., when they are derivatives of existing assets). This result suggests that, as asset markets get more complete, they become more susceptible to speculation and further financial innovation is more likely to be destabilizing.

Alp Simsek and Muhamet Yildiz, "Durable Bargaining Power and Stochastic Deadlines", January 2008 [Download]

Bargaining power in real bargaining situations occasionally becomes more stable, and these episodes may have non-trivial effects on the bargaining outcome. An example is the bargaining power of the parties in US congressional decision making, which becomes more durable immediately after a general election because the election determines how much control each party will have in the government for a while. To analyze the bargaining outcome in such situations, we develop a continuous-time bargaining model in which bargaining power evolves over time according to a stochastic process. We define a notion of durability for the bargaining power as a condition on the stochastic process and we show that durability plays a central role when agents are optimistic. In particular, when bargaining power becomes more durable after a date, optimistic agents are enticed to wait until that date, leading to a period of disagreement. In the context of congressional decision making, our result suggests that there would be more disagreements, e.g. fewer bills passed, in the period leading up to the general election than the period immediately after the election.
The "durability effect" is closely related to an empirical regularity in bargaining, the "deadline effect". Using the same argument that leads to the durability effect, we show that when agents are optimistic and bargaining power is durable around a period during which a (possibly stochastic) deadline is likely to arrive, the agents are enticed to delay the agreement until the deadline, as widely observed in experiments and real-world negotiations. We show that this deadline effect is stronger when the bargaining power is more durable around the likely time of deadline, or when the uncertainty about the deadline is smaller, or when the agents are more optimistic.

Economics Term Papers

Alp Simsek, "Analyzing Economic Effects of Constitutions with Weak Instruments", Term Paper for Econometrics Class at MIT, February 2007, Instructor: Jerry Hausman [Download]