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Market size matters: A model of excess volatility in large markets

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  • Kawakami, Kei

Abstract

I present a model of excess volatility based on speculation and equilibrium multiplicity generated by the self-fulfilling nature of information aggregation: if individuals trade more on the basis of speculation rather than hedging, then prices reveal more information on payoff risk which justifies less need for hedging. The findings show that multiplicity arises only in large markets. Across multiple equilibria, excess volatility is negatively associated with liquidity, trade volume, and traders׳ welfare. Other findings include: (i) excess volatility increases with payoff volatility and (ii) the asset that attracts more traders is more likely to experience a jump in excess volatility.

Suggested Citation

  • Kawakami, Kei, 2016. "Market size matters: A model of excess volatility in large markets," Journal of Financial Markets, Elsevier, vol. 28(C), pages 24-45.
    • Handle: RePEc:eee:finmar:v:28:y:2016:i:c:p:24-45
    DOI: 10.1016/j.finmar.2015.08.004
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    More about this item

    Keywords

    Asymmetric information; Excess volatility; Multiple equilibria; Price impact; Volume; Welfare;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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