Price distortions under coarse reasoning with frequent trade

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...

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Bibliographic Details
Published in:Journal of economic theory 2015-09, Vol.159, p.574-595
Main Authors: Steiner, Jakub, Stewart, Colin
Format: Article
Language:English
Subjects:
Agency theory
Assets
Bounded rationality
Categorization
Distortion
Economic forecasts
Economic theory
Economics
Futures market
Mathematical models
Prices
Pricing
Reasoning
Securities prices
Securities trading
Studies
Trade
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Summary: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.
ISSN:0022-0531
1095-7235
DOI:10.1016/j.jet.2015.07.011