Excessive Dynamic Trading: Propagation of Belief Shocks in Small Markets

Can belief shocks make trading excessive? We present a dynamic inventory man-agreement model in which belief shocks gradually propagate across traders, leading to the initiated trading activity which reduces traders’ welfare. Trading can be socially beneficial because smoothing heterogeneous asset positions saves inventory costs. Without belief shocks, traders focus on the socially beneficial trading and the dispersion of the asset positions decreases monotonically. We show that one-shot belief shocks induce a speculative trading, which aggregates information but slows down the convergence of the asset positions. When traders’ beliefs change quickly, the dispersion of the asset positions goes up, creating a cyclical pattern in volume. We also show that the high frequency trading ampli.es the impact of belief shocks by making the speculation less costly, and therefore steering traders away from the socially beneficial trading motive.