Price Distortions in High-Frequency Markets

35 Pages Posted: 2 Jun 2014

See all articles by Jakub Steiner

Jakub Steiner

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute)

Colin Stewart

University of Toronto - Department of Economics

Date Written: February 2014

Abstract

We study the effect of frequent trading opportunities and categorization on pricing of a risky asset. Frequent opportunities to trade can lead to large distortions in prices if some agents forecast future prices using a simplified model of the world that fails to distinguish between some states. In the limit as the period length vanishes, these distortions take a particular form: the price must be the same in any two states that a positive mass of agents categorize together. Price distortions therefore tend to be large when different agents categorize states in different ways, even if each individual’s categorization is not very coarse. Similar results hold if, instead of using a simplified model of the world, some agents overestimate the likelihood of small probability events, as in prospect theory.

Keywords: bounded rationality, coarse reasoning, high-frequency trading, price formation

JEL Classification: D53, D84

Suggested Citation

Steiner, Jakub and Stewart, Colin, Price Distortions in High-Frequency Markets (February 2014). CEPR Discussion Paper No. DP9817. Available at SSRN: https://ssrn.com/abstract=2444817

Jakub Steiner (Contact Author)

Charles University in Prague - CERGE-EI (Center for Economic Research and Graduate Education - Economics Institute) ( email )

P.O. Box 882
7 Politickych veznu
Prague 1, 111 21
Czech Republic
+420 605 286 947 (Phone)

HOME PAGE: http://www.cerge-ei.cz

Colin Stewart

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S 3G7
Canada

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