Swiss Finance Institute

Research Paper Series N15-03

Innovation, Delegation, and Asset

Price Swings
Yuki SATO
University of Lausanne and Swiss Finance InstituteETH Zrich

Electronic copy available at: http://ssrn.com/abstract=2568720

Innovation, Delegation, and Asset Price Swings

Yuki Sato
University of Lausanne and Swiss Finance Institute
February 22, 2015

Abstract

We propose a dynamic asset-market equilibrium model in which (1) an

innovative asset with as-yet-unknown average payoff is traded, and (2) investors delegate investment to experts. Experts can secretly renege on investors orders and take on leveraged positions in the asset in an effort to
manipulate investors beliefs, thereby attracting more orders and thus more
fees. Despite agents full rationality, the combination of experts moral hazard
and investors learning generates bubble-like price dynamics: gradual upswing,
overshoot, and reversal. Overshoot is pronounced and long-lasting if experts
charge high fees. Disclosure of experts positions dampens swings in asset
prices and improves welfare.
JEL classification: D80, G10, G23
Key words: asset price swings, delegated investment, innovation, learning, moral hazard,
signal jamming.

I am grateful to Margaret Bray, Dimitri Vayanos, and Denis Gromb for their guidance and encouragement. For helpful comments, I thank Elias Albagli, Ulf Axelson, Markus Brunnermeier, Amil Dasgupta,
Bernard Dumas, Vincent Fardeau, Itay Goldstein, Amit Goyal, Antonio Guarino, Stephane Guibaud,
Konstantin Milbradt, Joel Peress, Paul Woolley, as well as seminar participants at INSEAD and LSE.
Financial support from the Swiss Finance Institute and the Paul Woolley Centre for the Study of Capital
Market Dysfunctionality at LSE are gratefully acknowledged. All errors and omissions are my own.

University of Lausanne, UNIL-Dorigny, Extranef 235, CH-1015 Lausanne, Switzerland. E-mail:

yuki.sato@unil.ch.

Electronic copy available at: http://ssrn.com/abstract=2568720

Introduction

Bubble-like price movements have recurred in financial markets throughout history. Many
of them followed a common pattern: upswings, triggered by technological innovation, are
eventually followed by dramatic downswings, leading to persistent economic downturns.1
The 200708 financial crisis is no exception: rise in the U.S. housing prices, fueled by
financial innovation (i.e., securitization), and the subsequent reversal are the key factors
behind the global turmoil. Given their serious impacts on the real economy, it is important to understand the mechanism of asset price swings. Especially, studying the entire
cycleemergence of upswing, its overshoot, and eventual reversalcoherently in a unified
framework appears to be a critical task.
To tackle this problem, we develop a fully rational, dynamic asset-market equilibrium
model with delegated investment. We consider a market for a new and innovative asset,
whose average payoff is as-yet-unknown and subject to learning. Investors delegate their
investment to financial experts. We highlight the roles of (1) moral hazard associated
with delegated investment, and (2) investors learning about the assets average payoff.
Despite full rationality of long-lived agents, the combination of these two elements generates endogenous bubble-like price dynamics: gradual upswing, overshoot, and eventual
downswing.
Our model builds on the signal-jamming framework developed in Sato (2014). Unlike
Sato (2014), which does not provide implications for price dynamics, our paper explores
why bubble-like swings in security prices arise endogenously within a rational framework. We consider a discrete time model with finite horizon. There are one risky asset
and one riskless asset. Initially, the agents have large uncertainty about the risky assets average payoff. Over time, they learn about it based on the assets payoff history.
This asset is interpreted as a financial asset backed by an unprecedented and/or hard-to1

See Brunnermeier and Oehmke (2013) for a historical overview of bubbles and crises.

Electronic copy available at: http://ssrn.com/abstract=2568720

understand technologysuch as Internet stocks, biotech stocks, or sophisticated structured productswhose underlying profitability is initially unknown to most investors due
to the lack of track record and background knowledge. There is a continuum of investment
funds, each with a financial expert and an investor. The investor can invest directly in
the riskless asset. However, investing in the risky asset requires that she submits to the
expert a purchase order that specifies the number of shares of the asset to be purchased
on her behalf. Each period, the expert earns a delegation fee proportional to the order.
There are two items the investor cannot directly observe. First, the experts actual
purchase of the asset is unobservable to the investor. The expert can secretly renege on
the investors purchase order (at a cost) and boost the asset purchase by using leverage.
An example of such a fund can be a hedge fund adopting a flexible trading strategy that
is not communicated to investors. Second, the risky assets periodic payoff is not directly
observable to the investor.2 These two layers of unobservability create a signal-jamming
problem akin to Sato (2014). The investor tries to back out the risky assets payoffs from
the observed fund returns, learn about the assets average payoff, and submit purchase
orders on that basis. The higher the fund returns, the better the investors assessment of
the assets future prospects, hence the larger her purchase orders (and thus fees). So the
expert is inclined to boost the expected fund return by secretly levering up and increasing
the purchase of the risky asset, inflicting excessive risk on the investor. The investor is
not fooled in equilibrium because she is rational; nevertheless, the expert still reneges
and levers up since otherwise his funds future prospect would be underestimated by the
investor who believes that the expert is reneging secretly.
In equilibrium, the risky assets price path exhibits a bubble-like pattern on average:
it rises gradually, surpasses the benchmark level that would be obtained in the case in
2
An alternativeand perhaps more realisticassumption yielding exactly the same results is that
each investor can directly observe the assets payoff by incurring a small effort cost  > 0. Even if  is very
close to 0, it would be optimal for the investors to not observe the payoff directly because, in equilibrium,
they learn it perfectly and costlessly from the fund return anyway.

which the assets average payoff is perfectly known, and eventually falls and converges
to the benchmark level over time. Intuitively, these swings in the price are caused by
the combination of the following two effects that have opposing pressures on the assets
aggregate demand and thus on its price dynamics.
1. Learning effect. Initially, the investors estimate of the assets average payoff has low
precision. So, being risk averse, they hesitate to purchase the asset. The associated
demand for the asset is weak; thus, ceteris paribus, the initial price is low. But, as
the investors learning progresses over time, the precision of their estimate increases.
This leads them to increase purchase orders over time, having an upward pressure
on the assets demand and thus its price.
2. Leverage effect. Initially, the investors estimate of the assets average payoff has
low precision and hence is susceptible to the experts manipulation. This leads
the experts to renege on purchase orders and choose high leverage. The associated
aggregate demand is high; so, ceteris paribus, the initial price is high. But, as the
investors learning progresses, their estimate becomes precise and less subject to
manipulation. Accordingly, the experts deleverage over time, having a downward
pressure on the assets demand and hence its price.
In early periods, when the investors still have large uncertainty about the asset, the
learning effect dominates the leverage effect, initiating upswing in the price. On average,
the price overshoots the level of the benchmark case, in which neither of the above effects is
at work, because the experts use of leverage pushes up the assets aggregate demand and
its market-clearing price. As investors learning progresses, the learning effect weakens
and is dominated by the leverage effect, leading to downswing of the price. At some point,
the investors estimate becomes so precise that it is no longer worthwhile for the experts
to attempt to manipulate it. The leverage effect disappears, and the price converges to
4

the benchmark level over time.

The up-and-down swings are pronounced if the investors initial estimate has low precision. This is because for these swings to occur we need both the learning and leverage
effects to be strong, which is the case when the investors estimate has very low precision.
Thus, the model predicts that swings and overshooting in prices are more pronounced
for new and innovative assets with highly uncertain payoff characteristics than for oldeconomy assets already familiar in the market. This prediction is consistent with the
historical observation that bubble-like price movements tend to arise in times of technological change (e.g., railroads or the Internet) or financial innovation (e.g., securitization),
as noted by Brunnermeier and Oehmke (2013). We also show that the price overshoot is
pronounced and long-lasting when funds charge high fees, because higher fees incentivize
the experts to take on higher leverage, driving up the assets market-clearing price.
The equilibrium allocation is inefficient, as the experts attract less purchase orders
(and thus lower fees) than in the frictionless case. This is because the experts cannot
commit not to renege on the investors orders. We show that frequent disclosures of funds
positions alleviate this commitment problem and lower the experts leverage, thereby
achieve Pareto improvement and also dampen swings in asset prices. From a practical
point of view, such a policys implementability is high in that the authority does not
need to keep track of the characteristics of innovative assets or redistribute wealth across
agents. All they need to do is to ensure transparency so that investors learn about the
nature of these assets on their own.
Our paper is related to the theoretical literature providing rational explanations to
price anomalies such as bubbles or momentum and reversal. Vayanos and Woolley (2013)
also study momentum and reversal in a model with delegated investment. As noted in
their paper, however, delegated investment is not essential for momentum and reversal
to arise in Vayanos and Woolley (2013): the driving force is delay in the reaction of fund

flows to returns. We do not assume delays in agents reactions; in our model, delegation and the associated moral hazard problem are critical. The possibility that experts
attempt to manipulate investors beliefs by deviating from their equilibrium strategies
which Vayanos and Woolley (2013) exclude by assumptionis the key driver of price
swings in our model. Like our paper, Pastor and Veronesi (2009) develop a fully rational
model and obtain bubble-like patterns in the prices of new-economy assets. The key
ingredients of their model are a time lag between the introduction and adoption of a
new technology and investors learning during that lag. While investors learning plays
a central role also in our model, we do not distinguish the introduction and adoption of
a new technology; our results are driven by agency relationship in delegated investment
in which investors learning is potentially influenced by experts. DeMarzo, Kaniel, and
Kremer (2007) also study bubbles caused by technological innovation. While their model
is static and focuses on bubbles in real investment, our model studies dynamic bubble-like
pattensboth upswings and reversalsin security prices.
Our paper is also related to the literature on opacity/complexity and obfuscation in
financial markets. Sato (2014) is most closely related to ours: both papers feature signal
jamming associated with delegated investment. While Sato (2014) studies a stationary
equilibrium and therefore has no implications for asset-price dynamics, our focus is on
time-varying, bubble-like patterns of asset prices in a non-stationary equilibrium. Moreover, our modeling approach is more standard than that of Sato (2014): while Sato (2014)
assumes overlapping generations of short-lived risk-neutral investors whose decisions stem
from a decreasing-returns-to-scale assumption a` la Berk and Green (2004), we consider a
standard dynamic optimization problem of long-lived risk-averse investors. Carlin (2009)
and Carlin and Manso (2011) argue that financial professionals may deliberately obfuscate
their products to extract informational rents from unsophisticated investors. Financial
experts in our model also try to exploit less-informed investors strategically. But unlike

those papers, our focus is on the dynamics of security prices in competitive markets.
In recent years, a theoretical literature studying the equilibrium implications of delegated portfolio management has been growing (Allen and Gorton 1993; Shleifer and
Vishny 1997; Berk and Green 2004; Vayanos 2004; Cuoco and Kaniel 2011; Guerrieri and
Kondor 2012; He and Krishnamurthy 2012, 2013; Malliaris and Yan 2012; Kaniel and
Kondor 2013). To our knowledge, bubble-like price dynamicsupswing, overshoot, and
reversalare not yet discussed in this literature. Our paper contributes to this literature
by showing that, despite agents full rationality, portfolio delegation and the associated
moral hazard generate such patterns of equilibrium asset prices.3
The paper proceeds as follows. Section 2 presents the model. Sections 3 characterize
the equilibrium. Section 4 studies price dynamics. Section 5 discusses policy implications.
Section 6 concludes. All proofs are in the Appendix.

Model

Time t is discrete and finite: t = 0, ..., T + 1. Period T is the last period in which the
market is open and agents make decisions. In period T + 1, the agents just consume their
entire wealth. There is a single risky asset and a riskless asset. The riskless asset has an
infinitely elastic supply at an exogenous rate of return r > 0 and is freely accessible to all
agents. There are two classes of agents: investors and experts. The investors can purchase
the risky asset only through investment funds run by the experts. Each investor gives
capital to a fund, specifying the number of shares of the risky asset to be purchased on
her behalf. The expert can secretly lever up the investor capital and buy a larger number
of shares of the asset than asked by the investor. The experts leverage, the investors
3

Our paper is also related to the literature on career concerns and asset prices (Dasgupta and Prat
2008; Guerrieri and Kondor 2012; Dasgupta, Prat, and Verardo 2011). In these papers, fund managers
seek to influence investor beliefs about their ability. In our paper, experts try to influence investor
expectations about the innovative assets future prospects.

demand for the risky asset, and the assets price are determined in equilibrium.

2.1

Risky asset

In period t = 1, 2, ..., T + 1, the risky asset yields a per-share payoff t = + ut . The

transitory component ut is i.i.d. across time, normally distributed with mean 0 and variance 1/u , and unobservable to anyone. The average payoff is a constant drawn by
nature in period 0 from a normal distribution with mean 0 and variance 1/0 . The
agents do not observe directly, and learn about it over time based on the payoff history
t ]. Parameter
Ht { }t =1 . We denote the period-t estimate of given Ht by t E[|H
0 measures (the inverse of) the risky assets innovativeness. The asset with small 0 is
interpreted as an innovative asset whose cash flow is backed by an unprecedented and/or
hard-to-understand technologysuch as Internet stocks, biotech stocks, or sophisticated
structured productsbecause most market participants initially have large uncertainty
about such an assets average payoff due to the lack of track record and background
knowledge. The investors cannot directly observe the realized payoff t for all t, whereas
the experts can do so. Although it is unobservable, as shown later, in equilibrium the
investors learn t perfectly from the observed fund return.4
In period t = 0, ..., T , the asset is traded in the market at a publicly observable
market-clearing price, Pt . The assets supply S > 0 is constant over time. Let Rt+1
t+1 + Pt+1 (1 + r)Pt denote the excess return on the risky asset per share. We denote
t+1 E[Rt+1 |Ht ].
the expected excess return conditional on Ht by R
4

As noted in footnote 2, we could alternatively assume that each investor can observe t with a very
small effort cost  > 0. However small  is, the investors would choose not to observe t because they
learn it perfectly and costlessly from the fund return.

2.2

Delegated investment

There is a continuum with mass one of investment funds, each indexed by i [0, 1]. Fund
i consists of a risk-neutral expert and a risk-averse investor, who both live from t = 0 to
t = T + 1. For simplicity, we assume that investor i can neither invest in nor observe
activities in the other funds. This assumption eliminates the possibility that an expert
attracts an infinitely large amount of capital to have price impact in the asset market.
In each period t = 0, ..., T , investor i submits to expert i a purchase order, which
specifies the number of shares of the risky asset, yi,t [0, ), that the expert is supposed
to purchase on behalf of the investor. On top of the capital needed for this purchase
(Pt yi,t dollars), the investor pays yi,t dollars to the expert as the delegation fee, where
the fee rate > 0 is an exogenous parameter.
After receiving capital and fee from the investor, the expert buys the asset. Despite
being asked to purchase only yi,t shares, the expert can renege and buy (1 + i,t )yi,t
shares of the asset, where i,t [0, ) is the experts choice variable. We assume i,t is
unobservable to the investor and the expert cannot commit to his choice of i,t . Since the
expert has zero personal wealth, choosing i,t > 0 requires borrowing funds from outside
lenders. Thus, i,t is also a measure of the funds leverage. To choose i,t , the expert
incurs a nonpecuniary cost of reneging, i,t with > 0. This represents the cost of effort
to cook the books and/or manipulate the disclosure documents to make them look like
the expert adhered to the investors purchase order.5
In period t + 1, the funds period-t investment yields the total proceeds of Qi,t+1
Rt+1 (1 + i,t )yi,t + (1 + r)Pt yi,t dollars.6 The investor can directly observe Qi,t+1 .
5

It is not important that we allow only nonnegative i,t . The reason for assuming i,t 0 is that
it is compatible with the proportional reneging cost, i,t . If we allow i,t < 0, we would need a cost
function of the form |i,t |. This would reduce tractability of analysis while the results remain unchanged
because, in equilibrium, the experts may choose i,t > 0 but never i,t < 0. An alternative cost function
2
accommodating i,t < 0 is a quadratic form, i,t
/2. With this specification, the experts still do not
choose i,t < 0 in equilibrium and the model yields very similar results.
6
Qi,t+1 is computed as follows. In period t, the investor invests Pt yi,t dollars in the fund. The

2.3

Maximization problems

Each expert maximizes the discounted sum of his lifetime expected utilities, where his
within-period utility is the difference between the fee and the cost of reneging. That is,
E
expert is problem in period t = 0, ..., T , denoted by Pi,t
, is to choose i,t [0, ) to

maximize
E

" T t
X

(yi,t+

=0

 #
 E
,
i,t+ ) Fi,t

(2.1)

E
where (0, 1) is a discount factor common for all agents, and Fi,t
= {Qi, , yi, , i, , P , :

t} is his information set in period t.

I
Investor is problem in period t = 0, ..., T , denoted by Pi,t
, is to choose purchase order

yi,t and consumption ci,t to maximize the discounted sum of her lifetime expected utilities

" T t
X
=0

 #
 I
exp (ci,t+ ) Fi,t
,

(2.2)

I
= {Qi, , yi, , P :
where > 0 is the coefficient of constant absolute risk aversion and Fi,t

t} is her information set in period t, subject to her dynamic budget constraint

Wi,t+1 = Qi,t+1 yi,t + (1 + r)(Wi,t ci,t Pt yi,t ),

(2.3)

where Wi,t is her wealth in period t. Constraint (2.3) states that the investors next-period
wealth is the sum of the proceeds from the delegated investment net of fee and her own
investment in the riskless asset. In the final period t = T + 1, in which there is no market
for the asset, she simply consumes her entire wealth: Wi,T +1 = ci,T +1 .
expert borrows Pt i,t yi,t dollars from outside lenders and invests Pt (1 + i,t )yi,t dollars in the risky asset
(i.e., buys (1 + i,t )yi,t shares). In period t + 1, the fund receives t+1 (1 + i,t )yi,t dollars of payoff
from the asset, and obtains Pt+1 (1 + i,t )yi,t dollars from selling the asset in the market. The expert
pays back (1 + r)Pt i,t yi,t dollars to the lenders. Thus, the total proceeds from the funds investment is
Qi,t+1 = t+1 (1 + i,t )yi,t + Pt+1 (1 + i,t )yi,t (1 + r)Pt i,t yi,t = Rt+1 (1 + i,t )yi,t + (1 + r)Pt yi,t .

10

2.4

Definition of equilibrium

The equilibrium consists of the price Pt , the investors purchase order yi,t , and the experts
leverage i,t for i [0, 1] such that, for all t = 0, ..., T ,
I
,
1. given Pt and the others actions, investor i solves Pi,t
E
2. given Pt and the others actions, expert i solves Pi,t
, and

3. the risky assets market clears:

Z

(1 + i,t )yi,t di = S.

(2.4)

Analysis

This section characterizes the equilibrium of the model. We look for a linear equilibrium
such that Pt is linear in t on the equilibrium path. We follow the following steps to solve
the model.
1. Characterize the evolution of the agents estimates of (Section 3.1).
2. Conjecture a linear form of the equilibrium price. Also conjecture that the sequence
of each experts optimal leverage { }T=0 0 is deterministic (Section 3.2).
3. Specify the investors out-of-equilibrium beliefs (Section 3.3).
4. Solve each investors problem (Section 3.4) for her optimal purchase order yi,t .
5. Solve each experts problem (Section 3.5). Verify that { }T=0 is indeed deterministic
t+1 (Eq.(3.16)).
as conjectured in step 2, and obtain t as a function of R
t+1 as a function of t (Eq.(3.17)).
6. Impose market clearing (Section 3.6) and obtain R
11

 t+1 (Section 3.6; Figure 1).

7. Solve Eqs. (3.16) and (3.17) for two unknowns t and R
Verify that the equilibrium price is indeed linear as conjectured in step 2.

3.1

Evolution of estimates

Since is unobservable to anyone, all agents learn about it over time by Kalman filtering.
The experts, who observe Ht directly, update their period-t estimate t by
t = t t1 + (1 t )t ,

(3.1)

with the updating factor t (0, 1) that increases over time deterministically according
to t+1 = 1/(2 t ) from its initial value 1 = 0 /(0 + u ) (see Appendix A).
The investors, who cannot observe Ht directly, estimate based on the Ht that they
I
I
}t =1 denote the payoff history inferred
{i,
infer from the available information. Let Hi,t
I
is the value of t inferred by her. Her period-t estimate of is
by investor i, where i,t
I
I ], and her conditional expectation of the excess return is denoted
E[|F
denoted by i,t
i,t
I
I
I
I
i,t+1
by R
E[Rt+1 |Fi,t
]. If she infers that t is i,t
, she updates i,t
as

I
I
I
i,t
= t i,t1
+ (1 t )i,t
,

(3.2)

I
where i,0
= 0 is exogenously given, and the updating factor t is the same as that of

(3.1) (see Appendix A).

Importantly, the investors learning (3.2) potentially departs from (3.1) on off-theequilibrium paths because the experts can manipulate the investors inference by secretly
deviating from their equilibrium strategy (i.e., choosing i,t that is not anticipated by
the investors). However, on the equilibrium path the investors correctly anticipate i,t ;
I
consequently Hi,t
= Ht holds, and thus (3.2) coincides with (3.1).

12

3.2

Conjectures

First, we propose and later verify the following conjecture about the equilibrium price.
Conjecture 1 (Price). The equilibrium price for t = 0, ..., T is of the form

Pt = at tI bt

with tI

1
I
i,t
di,

(3.3)

where
at

TX
+1t 
=1

1
1+r


(3.4)

is a riskless discount factor and {b }T=0 > 0 is a deterministic sequence.

The first term of (3.3), at tI , is the present value of the average of all the investors
expectations about the assets future payoffs discounted at the riskless rate. The second
term, bt , involves risk premium. This term is time-varying because the premium demanded
Since there is no market
by the investors changes together with their learning about .
in period T + 1, we set PT +1 0 (i.e., aT +1 0 and bT +1 0). Note that every agent
knows the form of (3.3), and therefore can infer the investors average estimate tI from
observing Pt on the equilibrium path.
Second, we conjecture and later verify the experts equilibrium strategy as follows.
Conjecture 2 (Experts optimal strategy). There exists a deterministic sequence { }T=0
0 such that, for all i [0, 1], expert i optimally chooses i,t = t in period t = 0, ..., T on
I
the equilibrium path and also on off-the-equilibrium paths where i,t
6 t .
=

Conjecture 2 states that the experts optimal leverage is deterministic, irrespective of

his potential deviations in the past, {i, }t1
=0 .

13

3.3

Out-of-equilibrium beliefs

As shown later, all investors infer Ht correctly on the equilibrium path and therefore
So, on the equilibrium path, each investor observes Pt and
have the same estimate of .
confirms that the other investors average estimate tI =

Pt +bt
at

is the same as her estimate

I
I ] =
. That is, E[|H
based on her inferred payoff history Hi,t
i,t

Pt +bt
at

for all i and t on

the equilibrium path. However, on off-the-equilibrium paths where some agents deviate
from their equilibrium strategies, an investor may observe Pt and realize that her estimate
I ] does not equal
E[|H
i,t

Pt +bt
.
at

For such a case, we specify the following out-of-equilibrium

belief of investors.
I ] 6=
If E[|H
i,t

P t + bt
I
I ].
then i,t
= E[|H
i,t
at

(3.5)

I
) disagrees
That is, an investor whose estimate (based on her inferred payoff history Hi,t

with the observed price Pt would stick with her own estimate. We have two remarks on
(3.5).
Remark 1 (Comparison with REE models). One may argue that (3.5) is implausible because, based on the standard rational-expectations equilibrium (REE) logic, each
investor should revise her belief in favor of the price. Such an argument does not apply
to our model, as the model setting and the nature of analysis are fundamentally different
from those of the standard REE models. In asymmetric information models a` la Grossman and Stiglitz (1980), uninformed investors should indeed revise their estimates in favor
of the price because it reflects informed investors superior signals. Also, in differential
information models a` la Grossman (1976), investors should revise their estimates in favor
of the price because it aggregates all investors signals and smooths out their idiosyncratic
noises. In contrast, in our model, the price need not convey information superior to each
investors because no investor has information superior to other investors and no one has
private information that would be collectively useful. That is, each investor has no reason
14

to believe that the others average estimate is more informative than her own. On the
equilibrium path, all investors infer the same payoff history Ht and thus do not learn new
I ] is equal
information from Pt : each of them just confirms that her own estimate E[|H
i,t
to

Pt +bt
at

I ] 6=
(which equals tI on the equilibrium path). If E[|H
i,t

Pt +bt
at

on an off-the-

equilibrium path, she may potentially attribute the discrepancy to the following events:
I ] is biased because expert i has deviated from the equilibrium
(1) her estimate E[|H
i,t
strategy, (2) the others average estimate tI is biased because some other experts have
deviated, (3) Pt does not reflect tI in the form of (3.3) because some other investors
have deviated, or a combination of these three. The investor cannot conduct a statistical
inference as to which of these three events is more likely than the others, because all of
them are supposed to occur with probability zero. The out-of-equilibrium belief (3.5)
states that each investor attributes the discrepancy to (2) or (3) instead of (1).
Remark 2 (Unique linear price). There is another, important reason why the out-ofequilibrium belief of the form (3.5) is plausible: it ensures that Pt reflects the unbiased estimate t on the equilibrium path. Indeed, somewhat paradoxically, it is precisely because
each investor would prioritize her own estimate over Pt when there were a discrepancy between them that Pt reflects the unbiased t on the equilibrium path. To see this point, suppose to the contrary that each investor would prioritize Pt over her own estimate (that is,
I ] 6=
consider the out-of-equilibrium belief of the form: if E[|H
i,t

Pt +bt
at

I
then i,t
=

Pt +bt
).
at

Under such a belief, there would be infinitely many equilibrium prices of the form (3.3).
Specifically, Pt = at z bt for an arbitrary number z would support an equilibrium because
I
each investor observes Pt , revises her estimate to i,t
= z, and forms demand on that ba-

sis, which then consistently translates into the market-clearing price Pt = at z bt even
on the equilibrium path. Such a multiplicity of equilibria would significantly lower the
models predictive power. The out-of-equilibrium belief (3.5) eliminates this multiplicity
and guarantees that Pt reflects only t on the equilibrium path.
15

3.4

Investors optimization

We conjecture and later verify that investor is value function in period t = 0, ..., T + 1
is, for all i,
Vt (Wi,t ) = exp (At Wi,t Bt ) ,

(3.6)

+1
+1
where {A }T =0
and {B }T =0
are deterministic sequences obtained later. Function Vt () is

time-varying because the investors maximized expected utility changes over time as their
learning about progresses. The Bellman equation is




I
Vt (Wi,t ) = max exp(ci,t ) + E Vt+1 (Wi,t+1 )|Fi,t
.
ci,t ,yi,t

(3.7)

The following two lemmas characterize the investors optimization.

Lemma 1 (Investors value function). The investors value function (3.6) satisfies the
Bellman equation (3.7) if
At =

1 + at

for t = 0, ..., T

(3.8)

and AT +1 = , and

Bt =

T
X

s
Y

s=t

k=t


2
!
1
S

ln

+
ak
2t
(1+r)as

 

1 + ak
+ 1 ln 1 1+as ln 1+as
as
as
as
as

for t = 0, ..., T

(3.9)

and BT +1 = 0, where

1
u t+1
=
Vart [Rt+1 ]
(1 + at+1 (1 t+1 ))2

is the period-t precision of the risky assets excess return.

16

(3.10)

Lemma 2 (Investors purchase order). Given Pt , investor i asks the expert to buy

yi,t

I (1 + )
t R
i,t+1
t
=
At+1 (1 + t )2

(3.11)

shares of the risky asset.

The investors optimal order (3.11) can be viewed as a mean-variance solution, standard in CARA-normal setting. It is increasing in the after-fee expected fund return,
I
i,t+1
(1 + t ) , and is decreasing in the volatility of fund return, (1 + t )2 /t , and
R

the time-adjusted risk aversion, At+1 . There are three points worth noting. First, yi,t
is increasing in the asset return precision t , which measures how much the investors
learning has progressed. Over time, t increases as the uncertainty about is unraveled,
encouraging the risk-averse investor to increase yi,t . As shown later, this upward pressure
on yi,t generates upswing in the equilibrium price Pt . Second, yi,t depends on the term
(1 + t ) because the investor anticipates that the expert will renege on her purchase order
and buy (1 + t )yi,t shares. Importantly, it is the investors belief (t ) about the experts
choice and not the choice itself (i,t ) that affects yi,t , because i,t is unobservable. This is
the source of the experts moral hazard that is central to the following analyses. Third,
I , which
yi,t depends on the expected excess return from investor is point of view, R
i,t+1
t+1 on some off-the-equilibrium paths. On the equilibrium
is not necessarily equal to R
I
i,t+1
t+1 for all i and t because all the investors infer Ht correctly.
path, of course, R
=R

3.5

Experts optimization

The experts problem is solved in a similar fashion to Sato (2014). To verify that it is
indeed optimal for expert i to choose { }T=0 deterministically, we consider what would
happen if he deviated from his equilibrium play and instead chose an arbitrary sequence
of leverage {i, }T=0 6= { }T=0 even as investor i still believes that { }T=0 is played. Such
17

a deviation does not affect the assets prices because each expert has measure zero.
I
What would be investor is inference i,t+1
of the payoff t+1 that is unobservable to
I
her? The value of i,t+1
solves

I
+ Pt+1 (1 + r)Pt (1 + t ) = t+1 + Pt+1 (1 + r)Pt (1 + i,t ).
i,t+1

(3.12)

The right-hand side (RHS) is Rt+1 (1 + i,t ), whose value is known to investor i who
observes Qi,t+1 . It depends on the experts actual choice, i,t , and the true payoff, t+1 .
The left-hand side (LHS) is the decomposition of the RHS as inferred by investor i. It
depends on her incorrect belief about the experts action, t , and implies an erroneous
I
inferred payoff, i,t+1
. Rearranging (3.12), we have

I
i,t+1


= t+1 +


i,t t
Rt+1 .
1 + t

(3.13)

This implies that if the expert plays i,t > t and if Rt+1 > 0, then the investor will
I
overshoot her inference, i.e., i,t+1
> t+1 .

The investors erroneous perception about t+1 biases her learning subsequently. SpecifI
> t+1 then her estimates of and asset return will be both biased upward
ically, if i,t+1
I

I
> t+ and R
in future periods, i.e., i,t+
i,t+ +1 > Rt+ +1 for = 1, 2, ..., T t (see

Appendix C).7 When choosing i,t in period t, the expert takes into account the fact that
I
i,t+
he can potentially inflate the investors perceived expected returns, R
+1 ( 1), and

therefore her purchase orders, yi,t+ ( 1), by choosing i,t > t . Lemma 3 characterizes
his optimal choice in period t, both on and off the equilibrium path.
t+1 and as given, the experts optimal choice
Lemma 3 (Experts leverage). Taking R
t
7

For these overshoots to occur, the out-of-equilibrium belief (3.5) plays a role. It leads the investor
I
I
to stick by her own (high) estimate i,t+
when it disagrees with Pt+ . Her high estimate i,t+
, in turn,
leads her to expect both t+ +1 and Pt+ +1 to be high. Thus, given the observed Pt+ , she expects that
Rt+ +1 will also be high.

18

of leverage i,t is as follows.

If

t+1
t R
1 + t

> then i,t ,

= then i,t [0, ) (indifferent),

< then i,t = 0,

(3.14)

where
T t
X

t+ (1 + at+ +1 (1 t+ +1 ))
t (1t+1 )

At+ +1 (1 + t+
)
=1

t+
Y

!
k

for t = 0, ..., T 1 (3.15)

k=t+2

and T = 0.
Lemma 3 states that the expert chooses i,t by weighing the marginal gain from in t+1 /(1 + ), against the marginal
fluencing the investor beliefs in future periods, t R
t
cost, . The deterministic variable t measures the sensitivity of the experts expected
future gain to an increase in i,t . In t = 0, ..., T 1, t is positive because the expert
can potentially gain from influencing the investors future beliefs. However, T is zero
because there is no future in period T : since the investor makes no decisions in period
T + 1, the expert has no benefit from influencing her belief in period T .
Note that Lemma (3) only characterizes the choice of i,t optimal from expert is
personal perspective, taking the equilibrium level t as fixed. To determine t , we need
to ensure that investor is belief about i,t is consistent with the experts optimal choice.
t+1 is a deterministic variable; thus, the investors belief
As will be shown in Section 3.6, R
is consistent (that is, Conjecture 2 is correct) if and only if i,t = t in (3.14), or
(

t Rt+1
t = max 0,
1 .

(3.16)

Note that t = 0 if t is small enough. That is, the experts do not renege on the purchase
19

orders if the benefit of manipulating investor beliefs is small. Indeed, in period T they will
surely choose T = 0 because T = 0. If t is large enough, t is positive and increases
t+1 . This make sense: a large R
t+1 means a large marginal benefit for the experts
with R
from influencing the future investor beliefs by reneging (i.e., the LHS of (3.14) is large),
inducing them to increase leverage t . We will pin down the equilibrium values of t and
t+1 explicitly in Section 3.6 by imposing the market-clearing condition.
R

3.6

Equilibrium

The market-clearing condition (2.4) determines the assets expected return and the agents
I
i,t+1
actions. Plugging the investors optimal policy (3.11) into (2.4), and noting that R
=

t+1 holds for all i in equilibrium, we obtain R

t+1 as a function of t :
R
t+1 = At+1 S + .
R
t
1 + t

(3.17)

The first term on the RHS is the risk premium demanded by investors, which increases
with the degree of their risk aversion and decreases with the precision t of asset return.
The second term /(1 + t ) is the fee premium, i.e., the return that compensates
t+1 decreases
investors for the delegation fees they pay. Importantly, (3.17) implies that R
with the experts leverage t because the fee premium is decreasing in t . Why does the
fee premium decrease with t ? The reason is that the fee effectively serves as a fixed
cost of investment in the risky asset from the investors perspective. An increase in t
lowers the average cost per share of the asset purchased, leading to a lower fee premium
demanded by investors. Note that the risk premium does not depend on t despite the
fact that a rise in t increases the risk borne by investors, all else equal. This is because
each investor responds to the higher t by decreasing her purchase order yi,t so that the
total risk she bears remains the same.

20

R t +1

R t +1
A S

R t +1 = t +1 +
t
1 + t

t R t +1
1

t = max0,

(a) High t

(b) Low t

t+1 and the fund

Figure 1: Determination of the risky assets expected excess return R

leverage t
t+1 are obtained by solving the system of
Given t , the equilibrium levels of t and R
equations (3.16) and (3.17). The solutions are

t At+1 S
4
t = max 0,
+
+ 1
and
2

t
t

s
A S
2
2
At+1 S
1 At+1 S
4
t+1
t+1 = min
R
+ ,
+
+
.
t
2
t
2t
t

A2t+1 S 2
2t

(3.18)

(3.19)

Figure 1 illustrates the determination of (3.18) and (3.19). Panel (a) shows the case
with t > /((At+1 S/t +)). Since the experts have strong desire to influence investors
t+1 (see (3.16)), leading
future beliefs (i.e., t is large), they choose high leverage given R
t+1 decreases with t for the following
to t > 0 in equilibrium. The equilibrium level of R
t+1 , a rise in t induces the experts to increase t , which leads to
reason. For a given R
t+1 decreases (i.e., Pt
a higher aggregate demand (1 + t )yt for the risky asset. Thus, R
increases) to clear the market. Panel (b) is the case with t /((At+1 S/t +)). Here,

21

t is so small that the equilibrium leverage is t = 0. The resulting small aggregated

demand for the asset is accompanied by a low market clearing price and a high expected
t+1 .
return R
t+1 is identified, the equilibrium price is readily determined. Conjecture 1
Once R
t+1 )/(1 + r).8 This implies that
implies that Pt can be written as Pt = at tI (bt+1 + R
t+1 )/(1 + r), or
Conjecture 1 is correct if and only if bt = (bt+1 + R

bt =

TX
+1t 
=1

1
1+r

t+ .
R

(3.20)

That is, bt is the present value of the future expected excess returns.
Proposition 1 summarizes the equilibrium outcome of the economy.
Proposition 1. There is a linear equilibrium in which
1. the risky assets excess return Rt+1 is, conditional on t, normally distributed with
t+1 and precision t , which are given by (3.19) and (3.10), respectively;
mean R
2. the risky assets price is Pt = at t bt , where at and bt are given by (3.4) and (3.20),
respectively;
3. each experts leverage is i,t = t , given by (3.18);
4. each investor asks the expert to buy yi,t = S/(1 + t ) shares of the asset;
5. investors consumption in t = 0, ..., T is an affine function of wealth,
Wi,t
1
ct (Wi,t ) =
+
1 + at

at
1 + at

1
ln +
2t

S
(1 + r)at

2

!
+ Bt+1 + ln at ,

This is shown as follows. From (C.7) in Appendix C, all investors average expected excess return is
R1 I
R1 I

I
I

0 R
i,t+1 di = (1 + at+1 (1 t+1 )) 0 i,t di + at+1 t+1 t bt+1 (1 + r)Pt = (1 + at+1 )t bt+1
I )/(1+r).
(1+r)Pt . Rearranging this and noting that at = (1+at+1 )/(1+r), we have Pt = at tI (bt+1 +R
t+1
I

Since R
t+1 = Rt+1 in equilibrium for all t, the result follows.

I
R
t+1

22

where Bt is given by (3.9); in the final period t = T + 1, she consumes her entire
wealth, i.e., ci,T +1 = Wi,T +1 .
Although it is costly to renege on the investors order, each expert chooses t > 0 if
it gives him sufficiently large marginal benefit through manipulating the investors future
beliefs (i.e., if t is large enough). The investors understand the experts desire to fool
them and hence their beliefs are not manipulated on the equilibrium path; nevertheless,
the experts still renege on the investors orders and lever up. This is because, given the
investors beliefs that the experts will lever up, the experts indeed lever up optimally since
otherwise the funds future prospects would be underestimated by the investors. By itself,
this result is not surprising: it is in line with other signal-jamming modes (Holmstrom
1999; Stein 1989; Sato 2014). The primary purpose of this paper, which distinguishes
ours from existing works, is to examine the implication of the experts signal-jamming
behavior for the dynamics of security prices. We explore this issue in Section 4.

Dynamics: Asset Price Swings

This section studies the dynamics of Pt determined in Proposition 1. First, we show that
Pt on average exhibits a bubble-like pattern: gradual upswing, overshoot, and eventual
reversal. Second, we show that such a pattern is pronounced when (1) the asset is innovative in that its average payoff is highly uncertain when introduced to the market (i.e.,
low 0 ), and (2) funds charge high fees (i.e., high ).

4.1

Price path

t+1 .
To obtain the sequence of Pt , first we need to obtain the sequences of t , t , and R
1
As shown in Appendix E, the deterministic sequence { }T =0
is obtained by solving the

23

following difference equation of t , backward from the terminal values T = 0 and T = 0:





1 t+2 t+1 (1 + at+2 (1 t+2 ))
.
t = t+1 +

)
t+2
At+2 (1 + t+1

(4.1)

+1
+1
+1
We already know the deterministic values of { }T =1
, {a }T =0
, {A }T =0
, and { }T=0

from (A.5), (3.4), (3.8), and (3.10), respectively. Thus, together with (4.1), we can iden+1
}T =1
tify the deterministic values of { }T=0 and {R
backward by (3.18) and (3.19),
+1
respectively, which then determine the deterministic values of {b }T =0
by (3.20). Gener+1
ating a sequence of normal random payoffs { }T =1
, we compute the associated estimates
+1
+1
{ }T =1
by (3.1). Then we can simulate a path of the price, {P }T =0
, by Pt = at t + bt .

Panel (a) of Figure 2 plots a sample path of Pt (blue solid line). Here we assume that
So the obtained price
the agents have a correct prior expectation in t = 0, i.e., 0 = .
We also plot the benchmark
pattern is not driven by the agents incorrect prior about .
price path, denoted by PtB (red dashed line), which corresponds to a noninnovative
asset whose average payoff is publicly known in period 0 (i.e., 0 = and 0 = ).
Although we set T = 1, 000, we present only the first 200 periods in the figure because
our focus is on the price dynamics of an innovative asset, whose is highly uncertain to
the investors. For very large t, the asset is no longer innovative since the agents have
already learned with high precision. Also, showing the price paths of later periods is
not interesting economically: Pt simply converges to PtB .9
The innovative assets price Pt is highly volatile in early periods. This makes sense.
Since the precision of the agents estimate t is low in the early phase of learning, they
update t drastically when having a new realization of stochastic payoff t (that is, t is
9

After the periods shown in the figure, the path of Pt approaches that of PtB and stays almost flat
for most of the remaining periods. When the final period approaches, both of these price paths start to
fall (around t = 850) and reach zero in the final period (t = 1, 001). This price fall occurs because there
is no market in the very last period t = T + 1which is an inevitable assumption in this finite-period
settingand thus the investors cannot sell the asset in that period (i.e., PT +1 = 0). We do not view
this price fall in last periods as an economically relevant result because it is merely an artifact of the
finite-horizon assumption. Thus, we do not report it in the figure and focus on early periods.

24

25
24.5

Pt

24

PB
(Benchmark)
t

Price

23.5
23
22.5
22
21.5
21
20.5
0

20

40

60

80

100

120

140

160

180

200

Time: t

Price (average of 50,000 sample paths)

(a) Simulated price path.

22.3

Pt
PB
(Benchmark)
t

22.2

22.1

22

21.9

21.8
0

20

40

60

80

100

120

140

160

180

200

Time: t
(b) Average of 50,000 simulated price paths.

Figure 2: Price dynamics. We plot the time paths of Pt obtained in Proposition 1 and the
benchmark price PtB that would be obtained in the case in which is perfectly known in
t = 0. Panel (a) plots a simulated path. Panel (b) plots the average of 50,000 simulated
paths. The parameter values are r = 0.04, = 0.1, = 1, = 0.2, = 1/(1 + r), S = 10,
u = 5, = 1, 0 = 1, and T = 1, 000. We set 0 = 50 for Pt and 0 = for PtB .

25

4.5

2.5

3.5
3

1.5

2.5
2

1.5
1

0.5

0.5
0

50

100

150

200

Time: t

50

100

150

200

Time: t
(b) Experts leverage t

(a) Return precision t

Figure 3: Time paths of the risky assets return precision t 1/Vart [Rt+1 ] and the
experts equilibrium leverage t . The parameter values are the same as those of Figure 2.
small in early periods), making the price volatile. But the price becomes less volatile over
time because, as learning progresses, the agents become more confident about their
estimate: they do not change t so much with a new realization of t (that is, t increases
over time). Indeed, the conditional price volatility Vart [Pt+1 ] = a2t+1 (1 t+1 )2 /(u t+1 )
decreases with t. By contrast, if the asset is noninnovative the agents do not update their
estimate (i.e., t = for all t), and hence PtB is deterministic and almost flat in early
periods.
To see the overall trend of the price dynamics more clearly, we plot the average of
50,000 simulated price paths in panel (b) of Figure 2. The innovative assets price
Pt exhibits bubble-like dynamics on average: it rises gradually (upswing), surpasses
the noninnovative-asset benchmark PtB (overshoot), and then falls gradually (downswing). Around t = 140 in the figure, it starts increasing again and converges to PtB
over time.
Intuitively, the initial up-and-down swings in Pt are caused by the combination of the
following two effects that have opposing pressures on the assets aggregate demand and
therefore its price dynamics.
26

1. Learning effect. Initially, the investors estimate of the asset return has low precision;
i.e., t is small for small t. So, being risk averse, they hesitate to purchase the asset.
Thus, ceteris paribus, the associated aggregate demand is weak and the price is low.
But, as time goes on, the investors learn about and thus t increases (Figure 3(a)).
This encourages them to increase yi,t over time, having an upward pressure on the
aggregate demand and thus the price.
I
has low precision and is suscep2. Leverage effect. Initially, the investors estimate i,t

tible to manipulation; i.e., t is small for small t. So t is large, leading the experts
to choose high leverage t . Thus, ceteris paribus, the associated aggregate demand
is high and the price is high. But, as time goes on, the investors learn about
I
and thus i,t
becomes precise, lowering the experts desire to manipulate it (i.e., t

decreases). Accordingly, the experts deleverage over time (Figure 3(b)), having a
downward pressure on the aggregate demand and thus the price.
In sum, due to the learning (leverage) effect, the price tends to be low (high) initially
and then increases (decreases) over time; the combination of these two effects generates
the inverse-U pattern. In the noninnovative-asset benchmark, neither of these effects
exists because the agents do not conduct learning (i.e., t = u t) and the experts do
not use leverage (i.e., t = 0 t). For the parameter values used in Figures 2 and 3, the
learning effect dominates the leverage effect in early periods, initiating the upswing in Pt .
It even surpasses PtB . This overshoot is caused by the experts use of leverage: higher t
is associated with larger aggregate demand for the risky asset, pushing up the marketclearing price Pt . As learning unravels over time, the learning effect fades out because
the incremental increase in t diminishes over time towards 0; that is, t approaches u
asymptotically (Figure 3(a)). At some point, the leverage effect dominates the weakened
learning effect, leading to downswing in the average Pt (around t = 30 in Figure 2(b)).
Eventually, the investors estimate becomes so accurate that it is no longer beneficial for
27

the experts to use leverage to influence investor beliefs. That is, t reaches 0 and the
leverage effect disappears (around t = 140 in Figures 2(b) and 3(b)). Afterwards, the
average Pt increases over time due to the learning effect (which is weakened but still at
work), and converges to PtB as t converges to u .
Remark. The price pattern reported in Figure 2 resembles bubble-like price movements
observed in reality. Is it a bubble? The answer is no, if we define a bubble as a situation
in which an asset is overpriced even though investors are contemporaneously aware that
the price is too high (Allen, Morris, and Postlewaite 1993; Abreu and Brunnermeier 2003).
In our model, the fact that Pt overshoots PtB on average means that all agents know at
t = 0 that Pt > PtB is likely to occur in the near future periods. Also, the agents are
likely to realize ex post, after they have learned with a high precision, that Pt was higher
than PtB in early periods. However, when they are actually making investment decisions
in early periods, they are not sure whether Pt > PtB or Pt < PtB because they do not
know the benchmark level PtB that depends on they are still learning about. Indeed,
while Figure 2(a) reports a typical sample path in which overshoot occurs, it is possible
to obtain (rare) simulated paths such that Pt < PtB for all t.

4.2

Effect of assets innovativeness

Under what circumstances are price swings pronounced? This section examines how
the price dynamics change in response to a change in 0 (inverse of the risky assets
innovativeness).
Panel (a) of Figure 4 plots the average of 50,000 simulated paths of Pt for different
levels of 0 . The average price exhibits up-and-down swings only if 0 is small enough
(0 50 in the figure), i.e., only if the agents have sufficiently large uncertainty about
initially. For large 0 (0 300 in the figure), the learning effect is so weak that it is

28

Pt (average of 50,000 sample paths)

22.3

0=50

22.2

0=0.01
0=

22.1

22

0=600

0=300

21.9

21.8
0

20

40

60

80

100

120

140

160

180

200

180

200

Time: t

Pt/PBt (average of 50,000 sample paths)

(a) Effect of 0 (inverse of the risky assets innovativeness).

1.02

=0.1

=0.11

=0.08
=0.01

0.96
0

20

40

60

80

100

120

140

160

Time: t
(b) Effect of (fund fee rate).

Figure 4: Comparative statics. We plot the average of 50,000 sample price paths for
different levels of 0 (panel (a)) and (panel (b)). In panel (b), we normalize Pt by
the benchmark level PtB because PtB itself changes with . Unless otherwise noted, the
parameter values are the same as those of Figure 2.

29

already dominated by the leverage effect in t = 0, and thus the initial upswing does not
occur. Moreover, if 0 is very large (0 600), the experts leverage t is so low that even
overshoot does not occur on average. As 0 increases further, the price swings are toned
down, and the price path converges to that of the noninnovative-asset benchmark PtB as
0 .
Thus, the model predicts that swings and overshooting in prices are more pronounced
for new and innovative assets with highly uncertain payoff characteristics than for oldeconomy assets already familiar in the market. This prediction is consistent with the
historical observation that bubble-like price movements tend to arise in times of technological change (e.g., railroads or the Internet) or financial innovation (e.g., securitization),
as noted by Brunnermeier and Oehmke (2013).
Note that price swings are pronounced with small 0 because both the learning and
leverage effects are large when 0 is small. The intuition is as follows. Suppose that a
financial asset backed by an unprecedented and/or hard-to-understand technologysuch
as Internet stocks, biotech stocks, or structured productsis newly introduced to the
market. The investors have large uncertainty about such an assets average payoff due to
the lack of track record and background knowledge (i.e., 0 is small). On the one hand, the
investors, being risk averse, hesitate to purchase such an asset initially; but they increase
demand gradually as learning progresses, generating a gradual upswing in the price (the
learning effect). On the other hand, the experts, being motivated by career concerns, try
to exploit the as-yet-unknown nature of the asset. Initially, they take on high leverage and
invest in the asset aggressively in an effort to trick investors into believing that the asset
is more profitable than it really is, causing the price overshoot; however, as the assets
true nature becomes known to investors, experts lose their desire to influence the investor
beliefs and thus deleverage, causing an eventual downswing in the price (the leverage
effect).

30

4.3

Effect of fund fee

What is the impact of fund fee on the price dynamics? Panel (b) of Figure 4 plots the
average of 50,000 simulated paths of Pt /PtB for different levels of fee rate . Instead of
presenting both Pt and the benchmark PtB in the figure, we normalize Pt by PtB because PtB
itself changes with . The figure shows that with higher the price overshoot (Pt /PtB > 1)
is more pronounced and also lasts longer. The intuition is as follows. If increases, the
experts could collect higher fees for a given rise in the investors estimate. That is, the
marginal gain from increasing i,t (the LHS of (3.14)) increases with . Thus, a higher
leads them to take on higher leverage in equilibrium, driving up the assets aggregate
demand and thus its market-clearing price Pt . Note that a change in does not affect
the learning effect because the Kalman filter (3.1) is independent of . Solely because of
the leverage effect, the price path is pushed up by high . For any t, the experts derive a
larger marginal benefit from using leverage with higher . Thus, they choose positive t
for a long time if is large, leading to the long-lasting price overshoot.

Policy Implication: Inspection of Funds

This section discusses the models policy implication. We argue that imposing disclosure
requirements on funds can dampen asset price swings and also improve social welfare.
From a theoretical perspective, one may find it rather obvious that alleviating asymmetric
information restores economic welfare. Nonetheless, we believe this exercise is important
from a practical point of view: it highlights the policys practical advantage that the
authority does not need to wade through the information on the innovative asset or
redistribute wealth across agents. It only requires the authority to disclose funds positions
and then leave the rest to the market mechanism. Indeed, it can be costly for the authority
to keep track of the fast-paced changes of the market environment by conducting research

31

on the characteristics of new and innovative assets and work out policies tailored to them.
The exercise below demonstrates that what matters is not the nature of innovations but
the transparency of funds positions. If only their positions are transparent, investors will
back out innovative assets performances from the observed fund returns and learn about
their true nature on their own. This leads to low fund leverage, and thus stable price
dynamics and higher welfare.
We add one ingredient to the model setup of Section 2. In each period t, after leverage
i,t is chosen, the authority conducts a random (exogenous) inspection of each fund with
probability and discloses i,t to investor i. Thus, i,t remains unobservable with probability 1 . The model analyzed above is a special case with = 0. The equilibrium of
this economy is derived (see Appendix F) following steps that are similar to those used
in Section 3.
Proposition 2. Suppose that, in each period, each fund is inspected (and the leverage
is disclosed to the investor) with probability . Then all the equilibrium variables are
identical to those of Section 3 but with t replaced by (1 )t .
This makes sense. If the inspection occurs and i,t is disclosed, the investor will infer
t+1 correctly by observing Qi,t+1 , irrespective of i,t actually chosen. In other words,
the expert can potentially manipulate the investors inference only if i,t remains undisclosed, which occurs with probability 1 . Therefore, the experts career concern is now
effectively measured as t multiplied by 1 .
Proposition 2 implies that Pareto improvement is achieved by frequent disclosure requirement on investment funds.
Corollary 1. Increasing the probability of inspection improves social welfare: it does
not affect the investors expected utility but makes the experts better off.
Intuitively, an increase in achieves Pareto improvement because it reduces the ex32

Pt (average of 50,000 sample paths)

22.4

=0
22.2

=0.3
22

=0.5

21.8

21.6

=1

21.4

21.2
0

20

40

60

80

100

120

140

160

180

200

Time: t

Figure 5: Policy implication. Each period, the authority inspects funds with probability
and discloses their leverage. The figure plots the average of 50,000 sample price paths of
the unobservable leverage case for different levels of . The parameter values other than
are the same as those of Figure 2.
perts leverage t . Each investors expected utility is not affected by a decrease in t
because she adjusts her purchase order yi,t to undo the potential effect of t on her expected utility. Indeed, the investors value function when > 0 is identical to the one
obtained in Lemma 1 where = 0. On the other hand, each expert is better off if
increases for the following reason. The higher , the less likely that he can manipulate
investor beliefs and hence the lower his expected marginal gain from reneging on the
purchase order. This reduced marginal gain induces the expert to decrease leverage i,t ,
leading to a lower aggregate demand for the risky asset and to a lower market-clearing
price. The resulting higher expected return encourages investors to submit more purchase
orders, which increases fees and thus improves the experts expected utility.
Moreover, frequent disclosures of fund leverage dampen up-and-down swings and overshoot of the price. Figure 5 plots the average of 50,000 sample paths of Pt for different
levels of , ranging from 0 to 1. As increases, the experts marginal gain from reneging
decreases and thus the leverage effect on the price path is weakened. If is large enough
33

then the learning effect prevails, eliminating the price overshoot and downswing.

Conclusion

This paper develops a fully rational, dynamic asset-market equilibrium model in which (1)
a new and innovative asset with as-yet-unknown average payoff is traded (e.g., Internet
stocks, biotech stocks, or sophisticated structured products), and (2) investors delegate investment to experts. Over time, investors learn about the assets average payoff from fund
returns. Experts can secretly renege on investors purchase orders and take on leveraged
positions in the asset in an attempt to manipulate investors beliefs, thereby attracting
more orders and thus more fees. Despite full rationality of long-lived agents, the assets
equilibrium price exhibits bubble-like dynamics on average: gradual upswing, overshoot,
and eventual reversal. The up-and-down swings are caused by the combination of (1) the
learning effectan upward pressure on the price as the investors learning unravels the assets uncertainty over time, and (2) the leverage effecta downward pressure on the price
as the experts deleverage over time. The price tends to overshoot because the experts
use of leverage pushes up the assets aggregate demand and thus its market-clearing price.
The model predicts that swings and overshooting in prices are more pronounced for new
and innovative assets with highly uncertain payoff characteristics than for old-economy
assets already familiar in the market. Also, the overshoot tends to be pronounced and
long-lasting if funds charge high fees. Disclosure requirements on funds positions reduce
the experts use of leverage, thereby improve social welfare and also dampen swings in
asset prices.
For future research, it would be interesting to explore this papers idea in a model of
imperfectly competitive and/or illiquid financial markets, because in reality a significant
amount of innovative financial assets are traded in over-the-counter markets (where asset

34

prices are not made public) or thin markets (where investors have price impact). Studying
the relation between delegated investment and dynamics of such assets prices in an OTC
market model (e.g., Duffie, Garleanu, and Pedersen 2005) or in a double share auction
model (e.g., Kyle 1989) may yield further economic insights and policy implications.

References
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37

Appendix
A

Learning

t ] be the precision of the experts period-t estimate of .

By standard Kalman filtering,
Let t 1/Var[|H
a new observation of t will update the estimate of and its precision as follows:
t = t t1 + (1 t )t

for t

t1
,
t

(A.1)

where
t = t1 + u .

(A.2)

The initial value of t , 0 > 0, and the initial value of t , 0 > 0, are exogenously given. The initial value
of t is 1 = 0 /1 = 0 /(0 + u ). From (A.1) and (A.2), we have

t+1 =

t
t+1

t
t + u

(A.3)

and
t =

t1
t u
=
t
t

t =

u
.
1 t

(A.4)

Plugging (A.4) into (A.3) yields

t+1 =

u
1t
u
1t

+ u

1
.
2 t

(A.5)

I ]
The updating factor t is the same for (3.1) and (3.2). This is shown as follows. Let i,t 1/Var[|H
i,t
As in (A.2), i,t evolves as
be the precision of investor is estimate of .

i,t = i,t1 + u .

(A.6)

I
Since H0 and Hi,0
are both empty sets, i,0 = 0 for all i. Thus, (A.2) and (A.6) imply that i,t = t for

all i and t. So we have i,t1 /i,t = t1 /t = t , as required.

38

Proof of Lemmas 1 and 2

First, we derive the period-t precision of asset return, t 1/Vart [Rt+1 ]. To do so, it is useful to compute
the conditional volatility of t+1 :
1
1
1
Vart [t+1 ] = Vart [ + ut+1 ] =
+
=
t
u
u

1
t+1


1
1
1 +
=
.
u
u t+1

(B.1)

Plugging the price conjecture (3.3) into the definition of Rt+1 and using the investors learning rule (3.2),
the excess asset return is

Rt+1 t+1 + Pt+1 (1 + r)Pt

I
= t+1 + at+1 t+1
bt+1 (1 + r)Pt
Z 1
I
= t+1 + at+1
i,t+1
di bt+1 (1 + r)Pt
0

Z
= t+1 + at+1


t+1 i,t + (1 t+1 )t+1 di bt+1 (1 + r)Pt

= t+1 + at+1 t+1 tI + at+1 (1 t+1 )t+1 bt+1 (1 + r)Pt

= (1 + at+1 (1 t+1 )) t+1 + at+1 t+1 tI bt+1 (1 + r)Pt .

(B.2)

From (B.2) and (B.1), we have

2

Vart [Rt+1 ] = (1 + at+1 (1 t+1 )) Vart [t+1 ]

2

(1 + at+1 (1 t+1 ))
,
u t+1

(B.3)

which yields t as in (3.10).

Now, we derive the investors value function and investment policy. In the final period t = T + 1,
the investors do not have optimization problems. Each of them just consumes her entire wealth, i.e.,
ci,T +1 = Wi,T +1 . Thus, AT +1 = and BT +1 = 0. The investors problem in period t = 0, ..., T is solved
as follows. Using dynamic budget constraint (2.3) and conjectured value function (3.6), we have



At+1
I
E Vt+1 (Wi,t+1 )|Fi,t
= exp

Ri,t+1 (1 + t )yi,t yi,t + (1 + r)(Wi,t ci,t )


.
2 1
12 At+1 (1 + t )2 yi,t

B
t+1
t

39

(B.4)

From (B.4) and Bellman equation (3.7), the first-order condition (FOC) for yi,t is
1
I
i,t+1
R
(1 + t ) At+1 (1 + t )2 yi,t
= 0,
t

(B.5)

which yields
yi,t

I
t R
i,t+1 (1 + t )
=
.
At+1 (1 + t )2

(B.6)

From (B.4) and (B.6),





1
I
2 1
E Vt+1 (Wi,t+1 )|Fi,t
= exp A2t+1 (1 + t )2 yi,t
At+1 (1 + r)(Wi,t ci,t ) Bt+1 .
2
t

(B.7)

Market clearing implies yi,t = S/(1 + t ) in equilibrium. Plugging this into (B.7),




1
1
I
E Vt+1 (Wi,t+1 )|Fi,t
= exp A2t+1 S 2 At+1 (1 + r)(Wi,t ci,t ) Bt+1 .
2
t

(B.8)

Thus, Bellman equation (3.7) is rewritten as

Vt (Wi,t ) = max { exp(ci,t ) exp (t At+1 (1 + r)(Wi,t ci,t ))} ,

(B.9)

1
1
t ln + A2t+1 S 2 + Bt+1 .
2
t

(B.10)

ci,t

where

The FOC for ci,t is

exp(ci,t ) exp(t )At+1 (1 + r) exp (At+1 (1 + r)(Wi,t ci,t )) = 0

ln ci,t = t + ln (At+1 (1 + r)) At+1 (1 + r)(Wi,t ci,t )



+ At+1 (1 + r)Wi,t = ( + At+1 (1 + r)) ci,t

t + ln
At+1 (1 + r)



At+1 (1 + r)
1

ci,t =
Wi,t +
t + ln
.
+ At+1 (1 + r)
+ At+1 (1 + r)
At+1 (1 + r)

40

(B.11)

Plugging (B.11) back into (B.9), we have





At+1 (1 + r)

Vt (Wi,t ) = exp
Wi,t
t + ln
+ At+1 (1 + r)
+ At+1 (1 + r)
At+1 (1 + r)


At+1 (1 + r)

= exp
Wi,t
t
+ At+1 (1 + r)
+ At+1 (1 + r)




exp + At+1 (1 + r) ln At+1 (1 + r)





At+1 (1 + r)
ln
+ exp
+ At+1 (1 + r)
At+1 (1 + r)


At+1 (1 + r)

= exp
Wi,t
t
+ At+1 (1 + r)
+ At+1 (1 + r)
!
At+1 (1+r)

 +A


t+1 (1+r)
A
(1
+
r)
A
(1
+
r)
t+1
t+1

.
(B.12)
1+

Taking log to (B.12),

At+1 (1 + r)
Wi,t
t
+ At+1 (1 + r)
+ At+1 (1 + r)




At+1 (1 + r)
At+1 (1 + r)
At+1 (1 + r)
ln

+ ln 1 +
.
+ At+1 (1 + r)

At Wi,t Bt =

(B.13)

From (B.13) we have

At =

At+1 (1 + r)
+ At+1 (1 + r)

(B.14)

and

At+1 (1 + r)
Bt =
t +
ln
+ At+1 (1 + r)
+ At+1 (1 + r)

At+1 (1 + r)



At+1 (1 + r)
ln 1 +
.

(B.15)

Using (B.10), (B.15) is rearranged as

Bt =

1 2
2 1
2 At+1 S t

Bt+1 ln +




 .

At+1 (1+r)
At+1 (1+r)
+At+1 (1+r)
+At+1 (1+r)
+ At+1 (1 + r)
+
ln

ln

(B.16)

Solving (B.14) backward from the terminal value AT +1 = , we have


At =
=

1+

1
1+r


+

1
1+r

2

.
1 + at


+ +

1
1+r

T +1t !1

(B.17)

41

Using (B.17), (B.16) is rewritten as

Bt = mt (Bt+1 + nt ),

(B.18)

where

mt

at
,
1 + at

nt ln +

(B.19)
1
2

S
(1 + r)at

2

1
1
+
ln
t
at

1
at

1 + at
ln
at

1 + at
at


.

(B.20)

Bt =mt nt + mt mt+1 nt+1 + mt mt+1 mt+2 nt+2 + + mt mt+1 mT nT

!
T
s
X
Y
=
mk ns ,

(B.21)

Solving (B.18) backward from the terminal value BT +1 = 0, we have

s=t

k=t

which is equivalent to (3.9) in the main text.

Proof of Lemma 3

First, we determine investor is purchase order on an arbitrary off-the-equilibrium path where expert i is
deviating from his equilibrium strategy.
Lemma 4. If expert i plays (i,0 , ..., i,T ) when investor i believes that he plays (0 , ..., T ), then investor
is purchase order in period t = 1, ..., T is

+
yi,t = yt + yi,t
,

(C.1)

where
t+1 (1 + )
t R
t
yt
At+1 (1 + t )2

(C.2)

and
t

+
yi,t

t (1 + at+1 (1 t+1 )) X

At+1 (1 + t )
s=1

t
Y
k=s+1

!
k


(1 s )

i,s1 s1

1 + s1

Proof of Lemma 4: In order to prove Lemma 4, we prove the following two claims.
Qt
10
In (C.3), we abuse notation and set k=t+1 k 1.

42

Rs .10

(C.3)

I
I
I
), her estimate
, ..., i,t
= (i,1
Claim 1: If investor i believes that the payoff history up to period t is Hi,t

of in an arbitrary period t is
I
i,t
= t +

t
X

t
Y

s=1

k=s+1

I
(1 s )(i,s
s ).

(C.4)

I
Proof of Claim 1: For t = 0, we have i,0
= 0 (exogenous). For t = 1, using the updating rule (3.2),

I
I
i,1
=1 0 + (1 1 )i,1
I
= 1 0 + (1 1 )1 + (1 1 )(i,1
1 )
|
{z
} |
{z
}
1

misperception

I
=1 + (1 1 )(i,1
1 ).

For t = 2,
I
I
I
i,2
=2 i,1
+ (1 2 )i,2


I
I
=2 1 + (1 1 )(i,1
1 ) + (1 2 )2 + (1 2 )(i,2
2 )
I
I
1 ) + (1 2 )(i,2
2 )
= 2 1 + (1 2 )2 + 2 (1 1 )(i,1
{z
} |
|
{z
}
2

misperception

I
I
=2 + 2 (1 1 )(i,1
1 ) + (1 2 )(i,2
2 ).

Continuing this way, for an arbitrary t we have

I
I
i,t
= t + t t1 2 (1 1 )(i,1
1 )
I
+ t t1 3 (1 2 )(i,2
2 )

..
.
I
+ t (1 t1 )(i,t1
t1 )
I
+ (1 t )(i,t
t )
!
t
t
X
Y
I

= t +
k (1 s )(i,s
s ),
s=1

where (abusing notation somewhat) we set

k=s+1

Qt

k=t+1

k 1. (End of proof of Claim 1.)

43

Claim 2: Investor is expected excess asset return is

I
I
i,t+1
t+1 + (1 + at+1 (1 t+1 )) (i,t
R
=R
t ).

(C.5)

Proof of Claim 2: From (B.2), the expected excess return conditional on the true history Ht is
t+1 E[Rt+1 |Ht ] = (1 + at+1 (1 t+1 )) t + at+1 t+1 tI bt+1 (1 + r)Pt .
R

(C.6)

Similarly, the expected excess return from investor is perspective (conditional on her inferred history
I
Hi,t
) is

I
I
I
i,t+1
R
E[Rt+1 |Fi,t
] = (1 + at+1 (1 t+1 )) i,t
+ at+1 t+1 tI bt+1 (1 + r)Pt .

(C.7)

From (C.6) and (C.7) we obtain (C.5). (End of proof of Claim 2.)
I
Claim 2 shows that an overestimation of (i.e., i,t
> t ) leads to an overestimation of the excess

return (i.e., R
i,t+1 > Rt+1 ). Now Claims 1 and 2 can be used to rearrange the investors order (3.11) as
follows:

yi,t

I
t R
i,t+1 (1 + t )
=
At+1 (1 + t )2


t+1 (1 + )
t R
t
t
I
t+1 )
=
+
(R
R
At+1 (1 + t )2
At+1 (1 + t ) i,t+1
!


t
t
t+1 (1 + t )
Y
t R
t (1 + at+1 (1 t+1 )) X
I
k (1 s )(i,s
s ).
+
=
At+1 (1 + t )2
At+1 (1 + t )
s=1

(C.8)

k=s+1

Substituting (3.13) into (C.8) then yields

yi,t

t
t+1 (1 + t )
t R
t (1 + at+1 (1 t+1 )) X
=
+
At+1 (1 + t )2
At+1 (1 + t )
s=1

t
Y
k=s+1

!
k


(1 s )

i,s1 s1

1 + s1


Rs

+
=yt + yi,t
,

as required. (End of proof of Lemma 4.)

Lemma 4 shows that the investors order yi,t is the sum of two terms. The first, (C.2), is the order
on the equilibrium path. The second, (C.3), is an additional component on the off-the-equilibrium paths

where the expert is deviating. (This term is zero on the equilibrium path because i,s1 = s1
for all

44

s.) From the experts perspective, the equilibrium order (C.2) is independent of his actions and is thus
uncontrollable. Hence, the impact of his actions (i,0 , ..., i,t1 ) on the current order yi,t is summarized in
+
the off-equilibrium component (C.3). Given that Rs > 0 for s t, the investor orders additional yi,t
>0

shares of the asset in period t after the experts deviation i,s1 > s1
in period s 1. As is clear from

(3.11), this additional order is caused by an overshoot in the investors expectation of excess return (i.e.,

I
R
i,t+1 > Rt+1 ). The key for this to occur is the investors out-of-equilibrium belief (3.5), which leads
the investor to stick by her own estimate of when it disagrees with the all investors average estimate
I
tI implied by the price. Note that, on this off-the-equilibrium path, investor i is aware that i,t
is higher
I
than tI , but is unaware that it is too high: she (incorrectly) believes that i,t
is more accurate than tI .

As shown in (C.5), this overestimation of leads to an overshoot in the expectation of Rt+1 . Intuitively,
the investors high estimate of leads her to expect both t+1 and Pt+1 to be high; given the observed
current price Pt , these estimates lead her to expect that Rt+1 will also be high.
Now we prove Lemma 3. To simplify the experts period-t objective, note the following points.
The fee on the current order, yi,t , can be omitted from the original objective function (2.1)
because, from (3.11), yi,t is independent of the experts actual choice of i,t .
+
By Lemma 4, the future order yi,t+ ( = 1, 2, ..., T t) is linear in yt+ and yi,t+
. Since (2.1)
+
is linear in yi,t+ , it follows that (2.1) is linear in yt+ and yi,t+
. This implies that yt+ can be

omitted from (2.1) because the expert cannot influence yt+ by his choice of i,t . That is, only
+
yi,t+
is relevant for his choice of i,t .

Conjecture 2which is verified laterimplies that the experts current action (i,t ) does not affect
his own future actions (i,t+1 , ..., i,T ) both on and off the equilibrium path. Thus, his costs of
choosing leverage in future periods can be omitted from (2.1).
Taking these points into account, the experts period-t maximization problem reduces to

max

i,t [0,)

i,t + E

"T t
X

=1

+
E
Fi,t
yi,t+


where
t+

+
yi,t+

t+ (1 + at+ +1 (1 t+ +1 )) X

)
At+ +1 (1 + t+
s=1

t+
Y
k=s+1

!
k


(1 s )

i,s1 s1

1 + s1


Rs .

(C.9)

+
Since yi,t+
is a linear function of (i,0 , ..., i,t+ 1 ), the marginal effect of the experts current action

45

+
i,t on yi,t+
is independent of his actions in other periods, (i,0 , ..., i,t1 , i,t+1 , ..., i,t+ 1 ). Hence, in
+
yi,t+
given by (C.9), only the term corresponding to s = t + 1 is relevant for the choice of i,t . Thus, an

equivalent problem is
"T t
X

t+ (1 + at+ +1 (1 t+ +1 ))
max i,t +E

)
At+ +1 (1 + t+
i,t [0,)
=1

t+
Y

k=t+2

#



 E
i,t t

(1 t+1 )
Rt+1 Fi,t .
1 + t

This is rewritten as

max

i,t [0,)

i,t +


i,t t
t+1 ,
t R
1 + t

(C.10)

where
T
t
X

t+ (1 + at+ +1 (1 t+ +1 ))

t (1 t+1 )
)
At+ +1 (1 + t+
=1

t+
Y

!
k

for t = 0, ..., T 1

k=t+2

and T 0. Choosing i,t 0 to maximize (C.10), the FOC is given by (3.14) in the main text.

Proof of Proposition 1

Statements 15 are proved in the main text. Statement 6 follows by rearranging (B.11) with (B.17).

Dynamics of t

For t = T , we have T = 0. For t = 0, ..., T 1, from (3.15) we have

t = (1 t+1 )

T
t
X
=1

Let us denote

Qt+1

k=t+2

 t+
Y


k Mt+ , where Mt+

k=t+2

t+ (1 + at+ +1 (1 t+ +1 ))
.
)
At+ +1 (1 + t+

k 1 (by abuse of notation). Then we have

t
=Mt+1 + 2 t+2 Mt+2 + 3 t+2 t+3 Mt+3 + + T t t+2 t+3 T MT ,
1 t+1
t+1
=Mt+2 + 2 t+3 Mt+3 + 3 t+3 t+4 Mt+4 + + T t1 t+3 t+4 T MT .
1 t+2

46

These two equations yields the difference equation of t for t = 0, ..., T 1:

t
t+2
= Mt+1 +
t+1 .
1 t+1
1 t+2

(E.1)

Note that (A.5) implies 1 t+1 = (1 t+2 )/t+2 . Using this, (E.1) is rewritten as




1 t+2 t+1 (1 + at+2 (1 t+2 ))
.
t = t+1 +
)
t+2
At+2 (1 + t+1

(E.2)

From (E.2) and the terminal value T = 0, we obtain {t }Tt=0 by backward induction.

Proof of Proposition 2

Let i,t {1, 0} be an indicator variable that takes 1 if fund i is inspected in period t and 0 otherwise. We
I
determine the effect of a sequence of deviations (i,0 , ..., i,T ) on the payoff i,t+1
as inferred by investor

i. If i,t = 0 then, as in Section 3.5,

I
i,t+1
= t+1 +


i,t t
Rt+1 .
1 + t

I
However, if i,t = 1, then i,t+1
= t+1 irrespective of the chosen i,t because the investor can infer t+1

from the observed Qi,t+1 , yi,t , Pt+1 , Pt , and i,t . Thus, as in Lemma 4, investor is purchase order in
period t = 1, ..., T is

+
yi,t = yt + yi,t
,

where
t+1 (1 + )
t R
t
yt
At+1 (1 + t )2

and
t

+
yi,t

t (1 + at+1 (1 t+1 )) X

At+1 (1 + t )
s=1

t
Y

!
k


(1 s )1(i,s1 =0)

k=s+1

i,s1 s1

1 + s1


Rs ;

here 1(Z) is an indicator function that takes 1 if Z is true and 0 otherwise.

Following the same steps as in Appendix C, the experts problem reduces to

max

i,t [0,)

i,t +

47


i,t t
t Rt+1 ,
1 + t

(F.1)

where
T
t
X

t+ (1 + at+ +1 (1 t+ +1 ))
t (1 )(1 t+1 )

)
At+ +1 (1 + t+
=1
= (1 )t

t+
Y

!
k

k=t+2

for t = 0, ..., T 1

T 0. The second term of (F.1)the experts expected gain from influencing the investors
and
estimatesis proportional to 1 because the experts choice of i,t can influence investor inference of
t+1 only when i,t = 0, which occurs with probability 1 . Observe that the only difference between
e t = (1 )t in (F.1). Thus, this economys
(C.10) and (F.1) is that t in (C.10) is replaced by
equilibrium is equivalent to the one in Section 3.5 with t replaced by (1 )t .

48

ECF-SFI 06

25.1.2006

16:05

Page 24

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