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Irrational Financial Markets

Author

Listed:
  • Fabrice Rousseau

    () (Economics,Finance and Accounting, National University of Ireland, Maynooth)

  • Laurent Germain

    (Toulouse Business School, France)

  • Fabrice Rousseau

    () (Economics, National University of Ireland, Maynooth)

  • Anne Vanhems

    (Toulouse Business School, France)

Abstract

We analyze a model where irrational and rational traders exchange a risky asset with competitive market makers. Irrational traders misperceive the mean of prior information (optimistic/pessimistic bias), the variance of prior information (better/lower than average effect)and the variance of the noise in their private signal (overconfidence/underconfidence bias). When market makers are rational we obtain results identical to Kyle and Wang (1997). However if market makers are irrational, we obtain 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

  • Fabrice Rousseau & Laurent Germain & Fabrice Rousseau & Anne Vanhems, 2008. "Irrational Financial Markets," Economics, Finance and Accounting Department Working Paper Series n1870108.pdf, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  • Handle: RePEc:may:mayecw:n1870108.pdf
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    References listed on IDEAS

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    1. Gervais, Simon & Odean, Terrance, 2001. "Learning to be Overconfident," Review of Financial Studies, Society for Financial Studies, vol. 14(1), pages 1-27.
    2. Terrance Odean, 1998. "Volume, Volatility, Price, and Profit When All Traders Are Above Average," Journal of Finance, American Finance Association, vol. 53(6), pages 1887-1934, December.
    3. Noureddine Krichene, 2004. "Deriving Market Expectations for the Euro-Dollar Exchange Rate from Option Prices," IMF Working Papers 04/196, International Monetary Fund.
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    5. Kyle, Albert S & Wang, F Albert, 1997. " Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test?," Journal of Finance, American Finance Association, vol. 52(5), pages 2073-2090, December.
    6. Greenwood, Robin & Nagel, Stefan, 2009. "Inexperienced investors and bubbles," Journal of Financial Economics, Elsevier, vol. 93(2), pages 239-258, August.
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    13. Bloomfield, Robert & Libby, Robert & Nelson, Mark W., 2000. "Underreactions, overreactions and moderated confidence," Journal of Financial Markets, Elsevier, vol. 3(2), pages 113-137, May.
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    15. Thomas Oberlechner & Carol Osler, 2009. "Overconfidence in Currency Markets," Working Papers 02, Brandeis University, Department of Economics and International Businesss School.
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    Cited by:

    1. Stelios Bekiros, 2014. "Detecting nonlinear dependencies in foreign exchange markets: A multistep filtering approach," Working Papers 2014-182, Department of Research, Ipag Business School.

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    Keywords

    Irrationality;

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