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Failing to forecast rare events

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  • Bond, Philip
  • Dow, James

Abstract

Do more talented traders prefer to bet on and against rare events or common events? Bets on rare events include out of the money options. Bets against rare events include the carry trade and investment grade bonds. In a model where traders specialize, equilibrium pricing reflects trading ability: A market with more skilled traders has a larger bid ask spread. We show that lower skill traders bet on and against rare events, while higher skill traders bet on and against frequent events, leading to higher bid-ask spreads in common event assets, and reducing financial markets’ ability to predict rare events.

Suggested Citation

  • Bond, Philip & Dow, James, 2021. "Failing to forecast rare events," Journal of Financial Economics, Elsevier, vol. 142(3), pages 1001-1016.
    • Handle: RePEc:eee:jfinec:v:142:y:2021:i:3:p:1001-1016
    DOI: 10.1016/j.jfineco.2021.06.028
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    More about this item

    Keywords

    Bid ask spread; Information production; Rare event; Black swan;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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