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Correlated noise: Why passive investment might improve market efficiency

Alex Weissensteiner

Journal of Economic Behavior & Organization, 2019, vol. 158, issue C, 158-172

Abstract: Over the last decades passive investment products have continuously increased their market share. The efficiency of financial markets is identified to be the main reason for this development. We propose a theoretical model framework which illustrates that the causality can also be reversed, i.e. shows that the efficiency of markets might improve as consequence of passive investment. We analyze a market in which agents process noisy correlated signals and trade a single asset, and we derive a closed-form expression for their expected payoffs. For competitive market makers, we provide a unique pricing expression which leads to a fully-revealing equilibrium and efficient markets. On the contrary, we show that a monopolistic market maker induces frictions in the price-discovery process with partially-revealing equilibria and inefficient markets. Agents with highly correlated noise improve their expected payoffs by reducing the information processing activity, and by doing so they even increase market efficiency.

Keywords: Forecast precision; Efficient markets; Inefficient markets; Passive investment (search for similar items in EconPapers)
JEL-codes: C7 G14 (search for similar items in EconPapers)
Date: 2019
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