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Prospect Theory and market quality

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  • Pasquariello, Paolo

Abstract

We study equilibrium trading strategies and market quality in an economy in which speculators display preferences consistent with Prospect Theory (Kahneman and Tversky, [39]; Tversky and Kahneman, [63]), i.e., loss aversion and mild risk seeking in losses. Loss aversion (risk seeking in losses) induces speculators to trade less (more), and less cautiously (more aggressively), with their private information – but also makes them less (more) inclined to purchase private information when it is costly – in order to mitigate (enhance) their perceived risk of a trading loss. We demonstrate that these forces have novel, nontrivial, state-dependent effects on equilibrium market liquidity, price volatility, trading volume, market efficiency, and information production.

Suggested Citation

  • Pasquariello, Paolo, 2014. "Prospect Theory and market quality," Journal of Economic Theory, Elsevier, vol. 149(C), pages 276-310.
    • Handle: RePEc:eee:jetheo:v:149:y:2014:i:c:p:276-310
    DOI: 10.1016/j.jet.2013.09.010
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    More about this item

    Keywords

    Prospect Theory; Market liquidity; Volatility; Trading volume; Price efficiency; Endogenous information acquisition;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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