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Informed speculation with k-level reasoning

Hang Zhou

Journal of Economic Theory, 2022, vol. 200, issue C

Abstract: This paper investigates the effect of strategic reasoning on financial markets with a level-k thinking framework. A level-k speculator performs k rounds of iterative reasoning to infer information from asset prices. In contrast to the static rational expectations equilibrium, the level-k framework produces a unified theory of momentum and contrarian trading strategies. Besides, this paper discusses how the distribution of sophistication levels affects several market variables and it sheds new light on empirical patterns such as: (1) overreaction of asset prices, (2) the excess volatility puzzle, and (3) the excessive trading volume puzzle. Moreover, this paper explores whether the level-k strategy converges to the rational expectations equilibrium.

Keywords: Level-k thinking; Investors' sophistication; Market instability (search for similar items in EconPapers)
JEL-codes: D40 D43 D53 G02 (search for similar items in EconPapers)
Date: 2022
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DOI: 10.1016/j.jet.2021.105384

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