DP10629 Financial Markets where Traders Neglect the Informational Content of Prices

Author(s): Erik Eyster, Matthew Rabin, Dimitri Vayanos
Publication Date: May 2015
Keyword(s): behavioral finance, cursedness, financial markets, overconfidence, return predictability, trading volume
JEL(s): D53, D84, G02, G11, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10629

We present a model of a financial market where some traders are ``cursed'' when choosing how much to invest in a risky asset, failing to fully take into account what prices convey about others' private information. Cursed traders put more weight on their private signals than rational traders. But because they neglect that the price encodes other traders' information, prices depend less on private signals and more on public signals than rational-expectation-equilibrium (REE) prices. Markets comprised entirely of cursed traders generate more trade than those comprised entirely of rationals; mixed markets can generate even more trade, as rationals employ momentum-trading strategies to exploit cursed traders. We contrast our results to other models of departures from REE and show that per-trader volume with cursed traders increases when the market becomes large, while natural forms of overconfidence predict that volume should converge to zero.