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Price Distortions in High-Frequency Markets

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  • Jakub Steiner
  • Colin Stewart

Abstract

We study the effect of frequent trading opportunities and categorization on pricing of a risky asset. Frequent opportunities to trade lead to large distortions in prices if some agents forecast future prices using a simplified model of the world that fails to distinguish between some states. In the limit as the period length vanishes, these distortions take a particular form: the price must be the same in any two states that a positive mass of agents categorize together. Price distortions therefore tend to be large when different agents categorize states in different ways. We characterize the limiting prices in terms of rational expectations prices associated with a coarsened process. Similar results hold if, instead of using a simplified model of the world, some agents overestimate the likelihood of small probability events, as in prospect theory. In this case a set aside may be better than a flat or percentage subsidy. JEL Code: D83, D84, D53

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Bibliographic Info

Paper provided by Northwestern University, Center for Mathematical Studies in Economics and Management Science in its series Discussion Papers with number 1549.

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Date of creation: 25 May 2012
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Handle: RePEc:nwu:cmsems:1549

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Keywords: categorization; price distortion; trading frequency;

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  1. Jakub Steiner & Colin Stewart, 2006. "Contagion through Learning," ESE Discussion Papers 151, Edinburgh School of Economics, University of Edinburgh, revised 10 Aug 2007.
  2. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1989. "Positive Feedback Investment Strategies and Destabilizing Rational Speculation," NBER Working Papers 2880, National Bureau of Economic Research, Inc.
  3. Haltiwanger, John C & Waldman, Michael, 1989. "Limited Rationality and Strategic Complements: The Implications for Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 104(3), pages 463-83, August.
  4. Milo Bianchi & Philippe Jehiel, 2010. "Bubbles and Crashes with Partially Sophisticated Investors," Levine's Working Paper Archive 122247000000002180, David K. Levine.
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  6. John Haltiwanger & Michael Waldman, 1983. "Rational Expectations and the Limits of Rationality: An Analysis of Heterogeneity," UCLA Economics Working Papers 303, UCLA Department of Economics.
  7. Philippe BACCHETTA & Eric VAN WINCOOP, 2004. "Higher Order Expectations in Asset Pricing," FAME Research Paper Series rp110, International Center for Financial Asset Management and Engineering.
  8. Philippe Jehiel & Dov Samet, 2003. "Valuation Equilibria," Levine's Bibliography 666156000000000046, UCLA Department of Economics.
  9. Sendhil Mullainathan & Joshua Schwartzstein & Andrei Shleifer, 2008. "Coarse Thinking and Persuasion," The Quarterly Journal of Economics, MIT Press, vol. 123(2), pages 577-619, 05.
  10. Barberis, Nicholas & Shleifer, Andrei, 2003. "Style investing," Journal of Financial Economics, Elsevier, vol. 68(2), pages 161-199, May.
  11. Ernst Fehr & Jean-Robert Tyran, 2005. "Individual Irrationality and Aggregate Outcomes," Discussion Papers 05-09, University of Copenhagen. Department of Economics.
  12. Jehiel, Philippe, 2005. "Analogy-based expectation equilibrium," Journal of Economic Theory, Elsevier, vol. 123(2), pages 81-104, August.
  13. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
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