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Irrational Market Makers

Author

Listed:
  • Laurent Germain
  • Fabrice Rousseau
  • Anne Vanhems

Abstract

We analyze a model where irrational and rational informed traders exchange a risky asset with irrational market makers. Irrational traders misperceive the mean of prior information (optimistic/pessimistic bias) and the variance of the noise in their private signal (overconfidence/ underconfidence bias). Irrational market makers misperceive both the mean and the variance of the prior information. We show 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.

Suggested Citation

  • Laurent Germain & Fabrice Rousseau & Anne Vanhems, 2014. "Irrational Market Makers," Finance, Presses universitaires de Grenoble, vol. 35(1), pages 107-145.
  • Handle: RePEc:cai:finpug:fina_351_0107
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    More about this item

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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