Smooth Trading with Overconfidence and Market Power

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 (perma...

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Bibliographic Details
Published in:The Review of economic studies 2018-01, Vol.85 (1 (302)), p.611-662
Main Authors: KYLE, ALBERT S., OBIZHAEVA, ANNAA, WANG, YAJUN
Format: Article
Language:English
Subjects:
Beauty
Disputes
Endogenous
Inventory management
Normal distribution
Power
Studies
Trading
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Summary: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 meanrevert at the same rate as private signals. Actual inventories smoothly adjust towards 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.
ISSN:0034-6527
1467-937X
DOI:10.1093/restud/rdx017