Price Distortions in High-Frequency Markets

Jakub Steiner and Colin Stewart

No 9817, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We study the effect of frequent trading opportunities and categorization on pricing of a risky asset. Frequent opportunities to trade can lead to large distortions in prices if some agents forecast future prices using a simplified model of the world that fails to distinguish between some states. In the limit as the period length vanishes, these distortions take a particular form: the price must be the same in any two states that a positive mass of agents categorize together. Price distortions therefore tend to be large when different agents categorize states in different ways, even if each individual?s categorization is not very coarse. Similar results hold if, instead of using a simplified model of the world, some agents overestimate the likelihood of small probability events, as in prospect theory.

Keywords: Bounded rationality; Coarse reasoning; High-frequency trading; Price formation (search for similar items in EconPapers)
JEL-codes: D53 D84 (search for similar items in EconPapers)
Date: 2014-02
New Economics Papers: this item is included in nep-mst
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Working Paper: Price Distortions in High-Frequency Markets (2012)
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