When Overconfident Traders Meet Feedback Traders

Abstract:     
In this paper, we develop a model in which overconfident market participants and rational speculators trade against trend-chasers. We show that the growth and the burst of a financial bubble stem from positive feedback trading. However, the presence of overconfident traders and the risk aversion of the informed speculators enhance the strength of bubbles (creation and burst). The positive feedback trading enhances the negative serial correlation of prices and the volatility of prices. We show that positive feedback traders destabilize prices more than their overconfident opponents. Generally, overconfidence increases the volatility of prices and worsens the market efficiency. But, we show that in the presence of positive feedback trading, overconfidence improves the market efficiency and dampens the excess volatility. When negative feedback traders are present most of the comparative statics are reversed. We obtain that negative feedback traders can earn positive expected profit when their number is low enough.

Number of Pages in PDF File: 45

Keywords: Overconfidence, Positive feedback trading, Bubbles, Excess volatility, Market efficiency.

JEL Classification: D43, D82, G14, G24

working papers series