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Finance

2014/1 (Vol. 35)


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Previous Pages 107 - 145

Abstract

English

We analyze a model where irrational and rational informed traders exchange a risky asset with irrational market makers. Irrational traders misperceive the mean of prior information (optimistic/pessimistic bias) and the variance of the noise in their private signal (overconfidence/ underconfidence bias). Irrational market makers misperceive both the mean and the variance of the prior information. We show that moderately underconfident traders can outperform rational ones and that irrational market makers can fare better than rational ones. Lastly, we find that extreme level of confidence implies high trading volume.

Outline

  1. Related work
  2. Model
  3. The equilibrium
    1. Impact of market maker’s over/under-confidence
    2. Impact of market maker’s optimism/pessimism
  4. Impacts on financial markets
  5. Conclusion
  6. Appendix
    1. Proofs
      1. Proof of Proposition 1 (Irrational Market Makers)
      2. Comments on a Different Parameterization of the Model
    2. Extension: Two types of Irrational Traders

To cite this article

Laurent Germain, Fabrice Rousseau, Anne Vanhems, “ Irrational Market Makers ”, Finance 1/2014 (Vol. 35) , p. 107-145
URL : www.cairn.info/revue-finance-2014-1-page-107.htm.

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