Competition, Premature Trading and Excess Volatility
London School of Economics & Political Science (LSE) - Financial Markets Group; Bank of England
Monash University - Faculty of Business and Economics
London School of Economics & Political Science (LSE) - Financial Markets Group
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, G14working papers series
Date posted: March 15, 2012 ; Last revised: August 2, 2012
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