Conscious Trading of Unconsciousness

Abstract

We model financial market under-and over-reaction when some traders unconsciously neglect 'new ' risks (or opportunities) in risky asset payoffs. These unconscious traders trade 'as if ' there exist only conventional risks and are unaware of the participation of conscious traders who are informed about both conventional and new risks. Hence, the unconscious traders believe that the price is not informative and trade aggressively against price movement. This improves market liquidity and weakens the price overreaction arising from noise trading. With a moderate fractions of conscious and unconscious traders, conscious trading injects sufficient information about the new risks into equilibrium price, to which the unconscious traders underreact. Therefore, conscious trading of unconsciousness can generate momentum. When new risks affect multi-assets heterogonously, conscious trading of unconsciousness can lead to a cross-sectional momentum. Dynamic feedforwards of the uncertainty from later to earlier generations can significantly affect time series momentum and reversal.

Keywords: Rational expectation equilibrium, consciousness, momentum and reversal JEL classification: G12, G14

JEL Classification: G12, G14