Competition, Premature Trading and Excess Volatility

Abstract:     
A substantial body of research suggests that it is difficult to account for all of the asset price volatility in terms of news. This paper attempts to explain the excess volatility puzzle as a consequence of competitive interaction between market participants. We develop a model of competitive interaction in the presence of noisy, but verifiable information. Our model shows that in the presence of competitive pressures, market participants find it optimal to act prematurely on unverified, noisy information. This premature reaction leads to lower total profits and excess market volatility in equilibrium. Our model also suggests that the spike in volatility at the closing time of the market can be modelled as a direct consequence of premature trading.

Number of Pages in PDF File: 41

Keywords: Premature trading, Competition, Unverified Information, Excess Volatility

JEL Classification: G12, G14

working papers series