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Smooth Trading with Overconfidence and Market Power

Albert S Kyle, Anna Obizhaeva () and Yajun Wang

Review of Economic Studies, 2018, vol. 85, issue 1, 611-662

Abstract: We describe a symmetric continuous-time model of trading among relatively overconfident, oligopolistic informed traders with exponential utility. Traders agree to disagree about the precisions of their continuous flows of Gaussian private information. The price depends on a trader’s inventory (permanent price impact) and the derivative of a trader’s inventory (temporary price impact). More disagreement makes the market more liquid; without enough disagreement, there is no trade. Target inventories mean-revert at the same rate as private signals. Actual inventories smoothly adjust towards target inventories at an endogenous rate which increases with disagreement. Faster-than-equilibrium trading generates “flash crashes” by increasing temporary price impact. A “Keynesian beauty contest” dampens price fluctuations.

Keywords: Market microstructure; Price impact; Liquidity; Transaction costs; Double auctions; Information aggregation; Rational expectations; Agreement to disagree; Imperfect competition; Keynesian beauty contest; Overconfidence; Strategic trading; Dynamic trading; Flash crash (search for similar items in EconPapers)
JEL-codes: D8 D43 D47 G02 G14 (search for similar items in EconPapers)
Date: 2018
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Working Paper: Smooth Trading with Overconfidence and Market Power (2016) Downloads
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