Working Paper: NBER ID: w21224
Authors: Erik Eyster; Matthew Rabin; Dimitri Vayanos
Abstract: 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.
Keywords: Behavioral Finance; Cursed Traders; Trading Volume; Market Dynamics
JEL Codes: D53; D84; G02; G11; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Cursed traders (F19) | Increased trading volume (G15) |
| Increased number of cursed traders (F19) | Increased trading volume (G15) |
| Rational traders exploiting underreaction of prices from cursed traders (G41) | Increased trading volume (G15) |
| Increased market size (D40) | Greater per-trader volume (F14) |