Financial Markets Where Traders Neglect the Informational Content of Prices

74 Pages Posted: 1 Jun 2015

See all articles by Erik Eyster

Erik Eyster

London School of Economics & Political Science (LSE) - Department of Economics

Matthew Rabin

University of California, Berkeley - Department of Economics

Dimitri Vayanos

London School of Economics; Center for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: May 2015

Abstract

We present a model of a financial market where some traders are "cursed'' when choosing how much to invest in a risky asset, failing to fully take into account what prices convey about others' private information. Cursed traders put more weight on their private signals than rational traders. But because they neglect that the price encodes other traders' information, prices depend less on private signals and more on public signals than rational-expectation-equilibrium (REE) prices. Markets comprised entirely of cursed traders generate more trade than those comprised entirely of rationals; mixed markets can generate even more trade, as rationals employ momentum-trading strategies to exploit cursed traders. We contrast our results to other models of departures from REE and show that per-trader volume with cursed traders increases when the market becomes large, while natural forms of overconfidence predict that volume should converge to zero.

Keywords: behavioral finance, cursedness, financial markets, overconfidence, return predictability, trading volume

JEL Classification: D53, D84, G02, G11, G12, G14

Suggested Citation

Eyster, Erik and Rabin, Matthew and Vayanos, Dimitri, Financial Markets Where Traders Neglect the Informational Content of Prices (May 2015). CEPR Discussion Paper No. DP10629, Available at SSRN: https://ssrn.com/abstract=2613026

Erik Eyster (Contact Author)

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Matthew Rabin

University of California, Berkeley - Department of Economics ( email )

549 Evans Hall #3880
Berkeley, CA 94720-3880
United States

Dimitri Vayanos

London School of Economics ( email )

A350
Houghton Street
London WC2A 2AE
United Kingdom
+44 (0)20 7955 6382 (Phone)
+44 (0)20 7955 7420 (Fax)

Center for Economic Policy Research (CEPR)

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United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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