Trading, Price Setting and Volatility in Equity Markets Under Divergent Expectations and Adaptive Valuations
36 Pages Posted: 31 Aug 2006
Date Written: August 2006
For a market to be viable, participants must be heterogeneous. Traditional asymmetric information models achieve this by including informed, uninformed, and noise traders. We model heterogeneity differently by relaxing the assumption that identically informed agents form homogeneous expectations. Adaptive valuations follow as agents can change their assessments when the order flow reveals the valuations of others. We use simulation to illustrate the major findings of our model - path dependency, convergence to multiple equilibria, and an intra-day volatility structure. The analysis has implications for volatility surges following public as well as non-public information release, and for longer-run herding, bubbles, and crashes.
Keywords: Trading, price discovery, volatility, equity markets, divergent expectations, adaptive valuations, and market structure
JEL Classification: G10
Suggested Citation: Suggested Citation