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Smooth Trading with Overconfidence and Market Power

Albert Kyle (), Anna Obizhaeva () and Yajun Wang ()
Additional contact information
Albert Kyle: Robert H. Smith School of Business, University of Maryland
Yajun Wang: Robert H. Smith School of Business, University of Maryland

No w0226, Working Papers from Center for Economic and Financial Research (CEFIR)

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 toward 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: D43 D47 D8 G02 G14 (search for similar items in EconPapers)
Pages: 94 pages
Date: 2016-01
New Economics Papers: this item is included in nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Journal Article: Smooth Trading with Overconfidence and Market Power (2018) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:cfr:cefirw:w0226

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