Prospect Theory and Market Quality

Abstract

We study equilibrium trading strategies and market quality in an economy in which speculators display preferences consistent with Prospect Theory (Kahneman and Tversky, 1979; Tversky and Kahneman, 1992), i.e., loss aversion and mild risk seeking in losses. Loss aversion (risk seeking in losses) induces speculators to trade less (more), and less cautiously (more aggressively), with their private information – but also makes them less (more) inclined to purchase private information when it is costly – in order to mitigate (enhance) their perceived risk of a trading loss. We demonstrate that these forces have novel, nontrivial, state-dependent effects on equilibrium market liquidity, price volatility, trading volume, market efficiency, and information production.

Keywords: Prospect Theory, Market Liquidity, Adverse Selection, Loss Aversion, Risk Seeking, Endogenous Information Acquisition, Price Impact, Volatility, Trading Volume, Efficiency, Price Informativeness

JEL Classification: D82, G14