Prospect Theory and market quality

Paolo Pasquariello

Journal of Economic Theory, 2014, vol. 149, issue C, 276-310

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.

Keywords: Prospect Theory; Market liquidity; Volatility; Trading volume; Price efficiency; Endogenous information acquisition (search for similar items in EconPapers)
JEL-codes: D82 G14 (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (10)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:149:y:2014:i:c:p:276-310

DOI: 10.1016/j.jet.2013.09.010

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