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Irrational Financial Markets

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Author Info

  • Fabrice Rousseau

    ()
    (Economics, National University of Ireland, Maynooth)

  • Laurent Germain

    (Toulouse Business School, France)

  • Fabrice Rousseau

    ()
    (Economics, National University of Ireland, Maynooth)

  • Anne Vanhems

    (Toulouse Business School, France)

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    Abstract

    We analyze a model where irrational and rational traders exchange a risky asset with competitive market makers. Irrational traders misperceive the mean of prior information (optimistic/pessimistic bias), the variance of prior information (better/lower than average effect)and the variance of the noise in their private signal (overconfidence/underconfidence bias). When market makers are rational we obtain results identical to Kyle and Wang (1997). However if market makers are irrational, we obtain that moderately underconfident traders can outperform rational ones and that irrational market makers can fare better than rational ones. Lastly we find that extreme level of confidence implies high trading volume.

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    Bibliographic Info

    Paper provided by Department of Economics, Finance and Accounting, National University of Ireland - Maynooth in its series Economics, Finance and Accounting Department Working Paper Series with number n1870108.pdf.

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    Date of creation: 2008
    Date of revision:
    Handle: RePEc:may:mayecw:n1870108.pdf

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    Keywords: Irrationality;

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    References

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    1. James Dow & Gary Gorton, . "Noise Trading, Delegated Portfolio Management, and Economic Welfare," Rodney L. White Center for Financial Research Working Papers 19-94, Wharton School Rodney L. White Center for Financial Research.
    2. Robin Greenwood & Stefan Nagel, 2008. "Inexperienced Investors and Bubbles," NBER Working Papers 14111, National Bureau of Economic Research, Inc.
    3. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August.
    4. Robert J. Shiller, 1989. "Comovements in Stock Prices and Comovements in Dividends," NBER Working Papers 2846, National Bureau of Economic Research, Inc.
    5. Noureddine Krichene, 2004. "Deriving Market Expectations for the Euro-Dollar Exchange Rate From Option Prices," IMF Working Papers 04/196, International Monetary Fund.
    6. Simon Gervais & Terrance Odean, . "Learning To Be Overconfident," Rodney L. White Center for Financial Research Working Papers 5-97, Wharton School Rodney L. White Center for Financial Research.
    7. Terrance Odean, 1999. "Do Investors Trade Too Much?," American Economic Review, American Economic Association, vol. 89(5), pages 1279-1298, December.
    8. Takatoshi Ito, 1988. "Foreign Exchange Rate Expectations: Micro Survey Data," NBER Working Papers 2679, National Bureau of Economic Research, Inc.
    9. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    10. Thomas Oberlechner & Carol Osler, 2009. "Overconfidence in Currency Markets," Working Papers 02, Brandeis University, Department of Economics and International Businesss School.
    11. 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.
    12. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    13. Bloomfield, Robert & Libby, Robert & Nelson, Mark W., 2000. "Underreactions, overreactions and moderated confidence," Journal of Financial Markets, Elsevier, vol. 3(2), pages 113-137, May.
    14. Terrance Odean, 1998. "Are Investors Reluctant to Realize Their Losses?," Journal of Finance, American Finance Association, vol. 53(5), pages 1775-1798, October.
    15. 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.
    16. Terrance Odean, 1998. "Volume, Volatility, Price and Profit When All Traders Are Above Average," Finance 9803001, EconWPA.
    17. 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.
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