Do Rational Traders Frenzy?

42 Pages Posted: 22 Jun 1997

See all articles by Lones Smith

Lones Smith

University of Wisconsin at Madison - Department of Economics

Date Written: April 1996

Abstract

I develop a simple new model of strategic trade with endogenous timing, generalizing Glosten and Milgrom (1985): A competitive market maker faces in risk neutral traders with unit demands or supplies. It is private information whether any given trader is either informed, with a heterogeneous informative signal about the asset payo , or a pure noise trader planning to make a trade at a random time. The market is open for an exponential length of time. This structure is recursively soluble into a sequence of "subgames", and (despite the endogenous timing) I find there is a unique separating equilibrium. I prove that necessarily there is incomplete separation, since only informed traders whose signals are "good news" ever buy, and only those with "bad news" ever sell! I show that traders can only envision switching sides of the market if the underlying signal distribution has no neutral news signal. Finally, I conjecture that the answer to the title is "yes", that all trades are self-feeding, and accelerate the time schedule of any future trades. My analysis is greatly simplified by focusing on a facetious "competitive auction" model, where the market maker only wishes to sell units.

JEL Classification: G12, G14

Suggested Citation

Smith, Lones, Do Rational Traders Frenzy? (April 1996). Available at SSRN: https://ssrn.com/abstract=39147 or http://dx.doi.org/10.2139/ssrn.39147

Lones Smith (Contact Author)

University of Wisconsin at Madison - Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706-1393
United States
608-263-3871 (Phone)
608-262-2033 (Fax)

HOME PAGE: http://www.lonessmith.com

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