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Discussion Paper Details

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Title: Price Distortions in High-Frequency Markets

Author(s): Jakub Steiner and Colin Stewart

Publication Date: February 2014

Keyword(s): bounded rationality, coarse reasoning, high-frequency trading and price formation

Programme Area(s): Financial Economics and Industrial Organization

Abstract: We study the effect of frequent trading opportunities and categorization on pricing of a risky asset. Frequent opportunities to trade can lead to large distortions in prices if some agents forecast future prices using a simplified model of the world that fails to distinguish between some states. In the limit as the period length vanishes, these distortions take a particular form: the price must be the same in any two states that a positive mass of agents categorize together. Price distortions therefore tend to be large when different agents categorize states in different ways, even if each individual?s categorization is not very coarse. Similar results hold if, instead of using a simplified model of the world, some agents overestimate the likelihood of small probability events, as in prospect theory.

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Bibliographic Reference

Steiner, J and Stewart, C. 2014. 'Price Distortions in High-Frequency Markets'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9817