Trading Heterogeneity, Information Transparency and Market Efficiency
59 Pages Posted: 10 Feb 2015
Date Written: January 2015
Market inefficiency provides an opportunity for rational arbitrage. Nonetheless, investors may not necessarily act on such information even if they are informed. Instead, they extrapolate what the others are doing and decide strategically whether to do rational arbitrage or irrational speculation. As the market becomes more inefficient, coordination on rational arbitrage generates a higher probability of moving the price towards its efficient equilibrium, which increases investors' incentive to do rational arbitrage. The collective actions of all investors feedback on the asset price and therefore the market efficiency, which then affects investors' subsequent actions. The dynamic interaction between heterogeneous trading and market efficiency contribute to asset price bubbles and depressions. Increasing information transparency magnifies bubbles and depressions.
Keywords: heterogeneity, global games, nonlinear dynamics, bubble, depression, financial crisis
JEL Classification: G12, D53, D83
Suggested Citation: Suggested Citation