Monitoring and Manipulation: Asset Prices When Agents Are Marked-to-market

Trading in security markets is delegated. We study the “efficient markets” paradigm in the context of such agency relations. Principal-investors want to monitor and compensate their agent-traders using market security prices in “mark-to-market” contracts. This introduces an externality because security prices are informative only insofar as the agent-traders of other principal-investors have an incentive to produce information and trade accordingly. If the market is dominated by such delegated traders, then these traders can attempt to manipulate the market price by jointly shirking and buying or selling in the same direction. In this way, traders provide market “proof” that they have worked hard and deserve high compensation. We show that even if agent-traders can coordinate perfectly, there is no equilibrium in which all principal-investors ignore market prices. The extent of “market efficiency,” indexed by the delegated traders’ propensity of joint shirking, is endogenized. * We thank Michael Brennan, Charlie Kahn, Chester Spatt, seminar participants at the University of Wisconsin at Madison, Georgia State University, and the NBER 2006 Summer Institute for comments and suggestions. This is a much revised version of a paper previously entitled “Asset Prices When Agents are Marked-to-Market.” § School of Management, Yale University, New Haven, CT 06520-8200. §§ School of Economics and Management, Tsinghua University, Beijing 100084, China. E-mail: [email protected]. §§§ J. Mack Robinson College of Business, Georgia State University, Atlanta, GA 30303. Phone: (404) 4137346. E-mail: [email protected]. Gary B. Gorton Yale University and NBER Ping He Tsinghua University §§ Lixin Huang Georgia State University