We develop a model of the gambler's fallacy—the mistaken belief that random sequences should exhibit systematic reversals. We show that an individual who holds this belief and observes a sequence of signals can exaggerate the magnitude of changes in an underlying state but underestimate their duration. When the state is constant, and so signals are i.i.d., the individual can predict that long streaks of similar signals will continue—a hot-hand fallacy. When signals are serially correlated, the individual typically under-reacts to short streaks, over-reacts to longer ones, and under-reacts to very long ones. Our model has implications for a number of puzzles in finance, e.g. the active-fund and fund-flow puzzles, and the presence of momentum and reversal in asset returns.

We examine empirically how the supply and maturity structure of government debt affect bond yields and expected returns. We organize our investigation around a term-structure model in which risk-averse arbitrageurs absorb shocks to the demand and supply for bonds of different maturities. These shocks affect the term structure because they alter the price of duration risk. Consistent with the model, we find that the maturity-weighted-debt-to-GDP ratio is positively related to bond yields and future returns, controlling for the short rate. Moreover, these effects are stronger for longer-maturity bonds and following periods when arbitrageurs have lost money.

We propose a theory of momentum and reversal based on flows between investment funds. Flows are triggered by changes in fund managers' efficiency, which investors either observe directly or infer from past performance. Momentum arises if flows exhibit inertia, and because rational prices underreact to expected future flows. Reversal arises because flows push prices away from fundamental values. Besides momentum and reversal, flows generate comovement, lead-lag effects, and amplification, with these being larger for high idiosyncratic risk assets. A calibration of our model using evidence on mutual fund returns and flows generates sizeable Sharpe ratios for momentum and value strategies.

What determines the term structure of interest rates? Standard economic theory links the interest rate for maturity T to the willingness of a representative agent to substitute consumption between times 0 and T. The standard model contrasts sharply with a more informal view based on investors ’ preferred habitat, proposed by John Culbertson (1957) and Franco Modigliani and Richard Sutch (1966). According to the preferred-habitat view, there are investor clienteles with preferences for specific maturities, and the interest rate for a given maturity is influenced by the demand of the corresponding clientele and the supply of bonds with that maturity. For example, the typical clientele for long-term bonds are pension funds. An increase in their demand would be expected to raise prices of long-term bonds and thus lower long-term interest rates. In short, preferred habitat implies that there is price pressure in the bond market. While the preferred-habitat view has intuitive appeal, it has not entered into the academic mainstream, typically being relegated to a paragraph in MBA-level textbooks. One reason for this is the mixed findings in early empirical studies of the term structure. Specifically, between 1962 and 1964, the US Treasury and Federal Reserve raised the supply of short-term government debt while simultaneously lowering the supply of long-term debt. This program, known as Operation Twist, aimed to raise short-term interest rates, and so improve the balance of payments, while also lowering long-term rates to stimulate private investment. A number of papers evaluated Operation Twist, and while they reached different conclusions, none found

This document contains a list of one typo in the main text and six typos in the online appendix of the article. Each typo is followed by an explanation of why it is only a typo and does not affect the analysis in the article. The main text and online appendix refer to the documents in the journal’s website https://www.econometricsociety.org/publications/ econometrica/2021/01/01/preferred-habitat-model-term-structure-interest-rates.

ABSTRACT We develop a continuous‐time model of liquidity provision in which hedgers can trade multiple risky assets with arbitrageurs. Arbitrageurs have constant relative risk‐aversion (CRRA) utility, while hedgers' asset demand is independent of wealth. An increase in hedgers' risk aversion can make arbitrageurs endogenously more risk‐averse. Because arbitrageurs generate endogenous risk, an increase in their wealth or a reduction in their CRRA coefficient can raise risk premia despite Sharpe ratios declining. Arbitrageur wealth is a priced risk factor because assets held by arbitrageurs offer high expected returns but suffer the most when wealth drops. Aggregate illiquidity, which declines in wealth, captures that factor.

We propose a clientele-based model of the yield curve and optimal maturity structure of government debt. Clienteles are generations of agents at different lifecycle stages in an overlapping-generations economy. An optimal maturity structure exists in the absence of distortionary taxes and induces efficient intergenerational risksharing. If agents are more risk-averse than log, then an increase in the long-horizon clientele raises the price and optimal supply of long-term bonds—effects that we also confirm empirically in a panel of OECD countries. Moreover, under the optimal maturity structure, catering to clienteles is limited and long-term bonds earn negative expected excess returns.

We propose a multiperiod model in which competitive arbitrageurs exploit discrepancies between the prices of two identical risky assets traded in segmented markets. Arbitrageurs need to collateralize separately their positions in each asset, and this implies a financial constraint limiting positions as a function of wealth. In our model, arbitrage activity benefits all investors because arbitrageurs supply liquidity to the market. However, arbitrageurs might fail to take a socially optimal level of risk, in the sense that a change in their positions can make all investors better off. We characterize conditions under which arbitrageurs take too much or too little risk.

ABSTRACT We model a financial market where some traders of a risky asset do not fully appreciate what prices convey about others' private information. Markets comprising solely such “cursed” traders generate more trade than those comprising solely rationals. Because rationals arbitrage away distortions caused by cursed traders, mixed markets can generate even more trade. Per‐trader volume in cursed markets increases with market size; volume may instead disappear when traders infer others' information from prices, even when they dismiss it as noisier than their own. Making private information public raises rational and “dismissive” volume, but reduces cursed volume given moderate noninformational trading motives.

We analyze how asymmetric information and imperfect competition affect liquidity and asset prices. Our model has three periods: Agents are identical in the first, become heterogeneous and trade in the second, and consume asset payoffs in the third. We show that asymmetric information in the second period raises ex ante expected asset returns in the first, comparing both to the case where all private signals are made public and to that where private signals are not observed. Imperfect competition can instead lower expected returns. Each imperfection can move common measures of illiquidity in opposite directions.