Risk Seekers: Trade, Noise, and the Rationalizing Effect of Market Impact on Convex Preferences
78 Pages Posted: 9 May 2018 Last revised: 31 Dec 2019
Date Written: December 30, 2019
Long-held intuition dictates that information-based trade is impossible without exogenous noise. Risk seekers can resolve this conundrum. Even though such agents have negative risk aversion, they act as utility maximizers because they fully internalize their impact on prices. If their love of risk increases, information decreases in the aggregate, making prices noisier and returns more volatile. If public information becomes more precise, risk sharing decreases but welfare increases, contradicting the Hirshleifer effect. If private information becomes cheaper, liquidity always increases, rendering economies with risk seekers empirically distinct from economies with noise traders or random endowments.
Keywords: Rationality, inefficient markets, information acquisition, liquidity
JEL Classification: D01, D53, D82, E19, G12, G14
Suggested Citation: Suggested Citation