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Prospect Theory and market quality

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  • Pasquariello, Paolo

Abstract

We study equilibrium trading strategies and market quality in an economy in which speculators display preferences consistent with Prospect Theory (Kahneman and Tversky, [39]; Tversky and Kahneman, [63]), i.e., loss aversion and mild risk seeking in losses. Loss aversion (risk seeking in losses) induces speculators to trade less (more), and less cautiously (more aggressively), with their private information – but also makes them less (more) inclined to purchase private information when it is costly – in order to mitigate (enhance) their perceived risk of a trading loss. We demonstrate that these forces have novel, nontrivial, state-dependent effects on equilibrium market liquidity, price volatility, trading volume, market efficiency, and information production.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 149 (2014)
Issue (Month): C ()
Pages: 276-310

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Handle: RePEc:eee:jetheo:v:149:y:2014:i:c:p:276-310

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Web page: http://www.elsevier.com/locate/inca/622869

Related research

Keywords: Prospect Theory; Market liquidity; Volatility; Trading volume; Price efficiency; Endogenous information acquisition;

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References

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Cited by:
  1. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.

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