52 Pages Posted: 1 Jun 1998
Date Written: April 1998
People are overconfident. Overconfidence affects financial markets. How depends on who in the market is overconfident and on how information is distributed. This paper examines markets in which price-taking traders, a strategic-trading insider, and risk-averse market-makers are overconfident. Overconfidence increases expected trading volume, increases market depth, and decreases the expected utility of overconfident traders. Its effect on volatility and price quality depend on who is overconfident. Overconfident traders can cause markets to underreact to the information of rational traders. Markets also underreact to abstract, statistical, and highly relevant information, while they overreact to salient, anecdotal, and less relevant information.
JEL Classification: G12, G14
Suggested Citation: Suggested Citation