Market Size Matters:A Model of Excess Volatility in Large Markets

Kei Kawakami

Department of Economics - Working Papers Series from The University of Melbourne

Abstract: We present a model of excess volatility based on speculation and equilibrium multiplicity. Each trader has two distinct motives to trade: (i) speculation based on noisy signals, and (ii) hedging against endowment shocks. The key to equilibrium multiplicity is the self-fulfilling nature of information aggregation: if individuals trade relatively more on the basis of speculation rather than hedging, then prices reveal more information on payoff risk which in turn justifies less need for hedging. We first show that multiplicity arises only in large markets where aggregate shocks in prices are sufficiently more important than idiosyncratic shocks. We then show that (i) in a given equilibrium, excess volatility increases with payoff volatility, (ii) comparing across different equilib ria, excess volatility is negatively associated with liquidity, trading volume, and social welfare. We also show that an increase in market size either creates high-volatility equilibria or eliminates low-volatility equilibria. Among other things, the model predicts that given two assets identical in their fundamental properties, the one that attracts more traders overtime is more likely to experience a jump in excess volatility.

Keywords: Asymmetric information; Excess volatility; Multiple equilibria; Price impact; Volume; Welfare. (search for similar items in EconPapers)
Pages: 28 pages
Date: 2015-03
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Journal Article: Market size matters: A model of excess volatility in large markets (2016)
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