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Smooth Trading with Overconfidence and Market Power

Author

Listed:
  • Albert S. Kyle

    (Robert H. Smith School of Business, University of Maryland)

  • Anna Obizhaeva

    (New Economic School)

  • Yajun Wang

    (Robert H. Smith School of Business, University of Maryland)

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.

Suggested Citation

  • Albert S. Kyle & Anna Obizhaeva & Yajun Wang, 2016. "Smooth Trading with Overconfidence and Market Power," Working Papers w0226, New Economic School (NES).
    • Handle: RePEc:abo:neswpt:w0226
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    File URL: https://www.nes.ru/files/Preprints-resh/WP226.pdf
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    References listed on IDEAS

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    Cited by:

    1. Stepan Gorban & Anna A. Obizhaeva & Yajun Wang, 2020. "Trading in Crowded Markets," Working Papers w0275, New Economic School (NES).
    2. Albert S. Kyle & Anna Obizhaeva & Yajun Wang, 2016. "Beliefs Aggregation and Return Predictability," Working Papers w0231, New Economic School (NES).

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    More about this item

    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;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D43 - Microeconomics - - Market Structure, Pricing, and Design - - - Oligopoly and Other Forms of Market Imperfection
    • D47 - Microeconomics - - Market Structure, Pricing, and Design - - - Market Design
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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