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Smooth Trading with Overconfidence and Market Power

Author

Listed:
  • Albert S. Kyle

    () (Robert H. Smith School of Business, University of Maryland)

  • Anna Obizhaeva

    () (New Economic School)

  • Yajun Wang

    () (Robert H. Smith School of Business, University of Maryland)

Abstract

We describe a symmetric continuous-time model of trading among relatively overconfident, oligopolistic informed traders with exponential utility. Traders agree to disagree about the precisions of their continuous flows of Gaussian private information. The price depends on a trader’s inventory (permanent price impact) and the derivative of a trader’s inventory (temporary price impact). More disagreement makes the market more liquid; without enough disagreement, there is no trade. Target inventories mean-revert at the same rate as private signals. Actual inventories smoothly adjust toward target inventories at an endogenous rate which increases with disagreement. Faster-than-equilibrium trading generates “flash crashes” by increasing temporary price impact. A “Keynesian beauty contest” dampens price fluctuations.

Suggested Citation

  • Albert S. Kyle & Anna Obizhaeva & Yajun Wang, 2016. "Smooth Trading with Overconfidence and Market Power," Working Papers w0226, Center for Economic and Financial Research (CEFIR).
  • Handle: RePEc:cfr:cefirw:w0226
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    References listed on IDEAS

    as
    1. Alfonso Dufour & Robert F. Engle, 2000. "Time and the Price Impact of a Trade," Journal of Finance, American Finance Association, vol. 55(6), pages 2467-2498, December.
    2. Martijn Cremers & Ankur Pareek, 2015. "Short-Term Trading and Stock Return Anomalies: Momentum, Reversal, and Share Issuance," Review of Finance, European Finance Association, vol. 19(4), pages 1649-1701.
    3. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-168, February.
    4. Jiang Wang, 1993. "A Model of Intertemporal Asset Prices Under Asymmetric Information," Review of Economic Studies, Oxford University Press, vol. 60(2), pages 249-282.
    5. Foster, F. Douglas & Viswanathan, S., 1994. "Strategic Trading with Asymmetrically Informed Traders and Long-Lived Information," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(04), pages 499-518, December.
    6. Songzi Du & Haoxiang Zhu, 2014. "Welfare and Optimal Trading Frequency in Dynamic Double Auctions," NBER Working Papers 20588, National Bureau of Economic Research, Inc.
    7. Darrell Duffie, 2010. "Presidential Address: Asset Price Dynamics with Slow-Moving Capital," Journal of Finance, American Finance Association, vol. 65(4), pages 1237-1267, August.
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    Cited by:

    1. Albert S. Kyle & Anna Obizhaeva & Yajun Wang, 2016. "Beliefs Aggregation and Return Predictability," Working Papers w0231, Center for Economic and Financial Research (CEFIR).

    More about this item

    Keywords

    market microstructure; price impact; liquidity; transaction costs; double auctions; information aggregation; rational expectations; agreement-to-disagree; imperfect competition; Keynesian beauty contest; overconfidence; strategic trading; dynamic trading; flash crash;

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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