The Effect Of Trading Costs On An Asset Bubble

858 WordsNov 29, 20154 Pages
The model below shows the effect of trading costs in an asset bubble in four different scenarios. Looking at the first graph, a, the difference between these two quantities represents the “profits” that the asset owner thinks he is obtaining when he exercises the option to sell (Scheinkman and Xiong). So, when the trading cost is $0, the asset owner will sell his asset immediately when the trade becomes profitable, therefore these profits are extremely small. However, as the trading cost increase, the trading barrier increases along with it, as a result trading frequency is greatly reduced as increasing trading cost, as one would suspect. The interesting conclusion comes from figures 3c and 3d. They indicate not only do rising trading cost reduce the magnitude of the bubble, they also reduce the extra volatility component. But it is important to mention that the massive reduction in trading frequency may be offset by the increase in profits in each trade offsetting the reduction of the bubble. To summarize when trading cost are small, the value of the bubble and the extra volatility component is at its maximum potential. Whereas, increases in trading costs reduce the trading frequency, asset price volatility, and the option value (Scheinkman and Xiong). Despite this model being easier to interpret for the reader than an equation, this model emphasizes through various trading cost volatility can be controlled. Investors may be more reluctant to making an irrational decision
Open Document