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Informed speculation with k-level reasoning

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  • Zhou, Hang

Abstract

This paper investigates the effect of strategic reasoning on financial markets with a level-k thinking framework. A level-k speculator performs k rounds of iterative reasoning to infer information from asset prices. In contrast to the static rational expectations equilibrium, the level-k framework produces a unified theory of momentum and contrarian trading strategies. Besides, this paper discusses how the distribution of sophistication levels affects several market variables and it sheds new light on empirical patterns such as: (1) overreaction of asset prices, (2) the excess volatility puzzle, and (3) the excessive trading volume puzzle. Moreover, this paper explores whether the level-k strategy converges to the rational expectations equilibrium.

Suggested Citation

  • Zhou, Hang, 2022. "Informed speculation with k-level reasoning," Journal of Economic Theory, Elsevier, vol. 200(C).
    • Handle: RePEc:eee:jetheo:v:200:y:2022:i:c:s0022053121002015
    DOI: 10.1016/j.jet.2021.105384
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    Cited by:

    1. Burkhard C. Schipper & Hang Zhou, 2022. "Level-k Thinking in the Extensive Form," Working Papers 352, University of California, Davis, Department of Economics.

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    More about this item

    Keywords

    Level-k thinking; Investors' sophistication; Market instability;
    All these keywords.

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles

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