Trading on Sunspots
In a model with multiple Pareto-ranked equilibria we add trade in assets that pay based on the realization of a sunspot. Asset trading restricts the equilibrium set in a way that raises welfare by eliminating equilibria with a high likelihood of disasters. When the probability of a disaster is high enough, the coordination game becomes like a prisoner’s dilemma situation in which the high-output equilibrium disappears because the portfolios that agents choose induce them to produce less. We derive an upper bound on the disaster probability, we derive asset pricing implications including the disaster premium, and we study the effect on stock prices of news shocks to beliefs.
Neither author has conflicts of interest and neither has anything to disclose. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.