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Speculating against an overconfident market

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  • Jordi Caballe
  • Jozsef Sakovics

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Abstract

We distinguish two components of self-confidence in a financial market: private confidence measures the self-confidence level of speculators, while public confidence measures the confidence level they attribute to their competitors. We then study how independent changes in these components affect the equilibrium trading strategies. We conduct the analysis in a financial market with imperfect competition where investors submit limit orders. We calculate the unique linear symmetric equilibrium as well as the major indicators of the market. In addition to providing a partial explanation for the excess volatility of asset prices as well as for trading volume unexplained by the arrival of new information, our model highlights the differences between the effects of public versus private confidence.

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Bibliographic Info

Paper provided by Edinburgh School of Economics, University of Edinburgh in its series ESE Discussion Papers with number 62.

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Length: 37
Date of creation: Apr 2004
Date of revision:
Handle: RePEc:edn:esedps:62

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Keywords: overconfidence; financial markets; imperfect competition;

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  1. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, . "Noise Trader Risk in Financial Markets," J. Bradford De Long's Working Papers _124, University of California at Berkeley, Economics Department.
  2. Dunne, T. & Roberts, M.J. & Samuelson, L., 1988. "Pattenrs Of Firm Entry And Exit In U.S. Manufacturing Industries," Papers 1-88-2, Pennsylvania State - Department of Economics.
  3. Terrance Odean, 1999. "Do Investors Trade Too Much?," American Economic Review, American Economic Association, vol. 89(5), pages 1279-1298, December.
  4. Margaret A. Neale & Max H. Bazerman, 1983. "The role of perspective-taking ability in negotiating under different forms of arbitration," Industrial and Labor Relations Review, ILR Review, Cornell University, ILR School, vol. 36(3), pages 378-388, April.
  5. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-78, September.
  6. Brad M. Barber & Terrance Odean, 2000. "Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," Journal of Finance, American Finance Association, vol. 55(2), pages 773-806, 04.
  7. Kyle, Albert S & Wang, F Albert, 1997. " Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test?," Journal of Finance, American Finance Association, vol. 52(5), pages 2073-90, December.
  8. Dan Lovallo & Colin Camerer, 1999. "Overconfidence and Excess Entry: An Experimental Approach," American Economic Review, American Economic Association, vol. 89(1), pages 306-318, March.
  9. Caballe, Jordi, 1992. "Market versus limit orders," Economics Letters, Elsevier, vol. 40(3), pages 339-344, November.
  10. Roll, Richard, 1984. "Orange Juice and Weather," American Economic Review, American Economic Association, vol. 74(5), pages 861-80, December.
  11. Kyle, Albert S, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Wiley Blackwell, vol. 56(3), pages 317-55, July.
  12. Gervais, Simon & Odean, Terrance, 2001. "Learning to be Overconfident," Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 1-27.
  13. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
  14. Rochet, J.C. & Vila, J.L., 1993. "Insider Trading Without Normality," Papers 93.b, Toulouse - GREMAQ.
  15. Terrance Odean, 1998. "Volume, Volatility, Price and Profit When All Traders Are Above Average," Finance 9803001, EconWPA.
  16. Palomino, Frederic, 1996. " Noise Trading in Small Markets," Journal of Finance, American Finance Association, vol. 51(4), pages 1537-50, September.
  17. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  18. Terrance Odean, 1998. "Volume, Volatility, Price, and Profit When All Traders Are Above Average," Journal of Finance, American Finance Association, vol. 53(6), pages 1887-1934, December.
  19. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
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Cited by:
  1. Michailova, Julija, 2010. "Overconfidence and bubbles in experimental asset markets," MPRA Paper 26388, University Library of Munich, Germany.
  2. Diego Garcia & Francesco Sangiorgi & Branko Urosevic, 2004. "Overconfidence and market efficiency with heterogeneous agents," Economics Working Papers 786, Department of Economics and Business, Universitat Pompeu Fabra.
  3. Chuang, Wen-I & Susmel, Rauli, 2011. "Who is the more overconfident trader? Individual vs. institutional investors," Journal of Banking & Finance, Elsevier, vol. 35(7), pages 1626-1644, July.
  4. Glaser, Markus & Weber, Martin, 2003. "Overconfidence and Trading Volume," Sonderforschungsbereich 504 Publications 03-07, Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim.
  5. Gelinde Fellner & Sebastian Krügel, 2012. "Judgmental Overconfidence and Trading Activity," Jena Economic Research Papers 2012-057, Friedrich-Schiller-University Jena, Max-Planck-Institute of Economics.
  6. Glaser, Markus & Weber, Martin, 2009. "Which past returns affect trading volume?," Journal of Financial Markets, Elsevier, vol. 12(1), pages 1-31, February.
  7. Beracha, Eli & Fedenia, Mark & Skiba, Hilla, 2014. "Culture's impact on institutional investors' trading frequency," International Review of Financial Analysis, Elsevier, vol. 31(C), pages 34-47.
  8. Dennis Dittrich & Werner Güth & Boris Maciejovsky, . "Overconfidence in Investment Decisions: An Experimental Approach," Papers on Strategic Interaction 2001-03, Max Planck Institute of Economics, Strategic Interaction Group.
  9. Michailova, Julija, 2010. "Development of the overconfidence measurement instrument for the economic experiment," MPRA Paper 26384, University Library of Munich, Germany.
  10. Palomino, Frederic & Sadrieh, Abdolkarim, 2011. "Overconfidence and delegated portfolio management," Journal of Financial Intermediation, Elsevier, vol. 20(2), pages 159-177, April.

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