Working Paper: CEPR ID: DP9817
Authors: Jakub Steiner; Colin Stewart
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.
Keywords: bounded rationality; coarse reasoning; high-frequency trading; price formation
JEL Codes: D53; D84
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| frequent trading opportunities (G14) | significant price distortions (P22) |
| agents categorizing states together (H70) | prices become identical across those states (D41) |
| trading frequency increases (G14) | prices in categorized states become identical (D41) |
| coordination of individual expectations among agents (D84) | price convergence across states (H73) |
| trading frequency increases (G14) | speculative motive grows stronger (D84) |
| speculative motive grows stronger (D84) | price distortions manifest as sudden large price adjustments (E30) |
| high trading frequency (G14) | agents' forecasts become constant across larger sets of states (C53) |