The Noise is in the Mind: Trading Equilibria with Transparent Prices

Department of Economics and Decision Sciences

Speaker:  Franz Ostrizek (Sciences Po)

Room T-019

Abstract: 

We investigate the behavioral foundations of informed trade. We extend the canonical Kyle '89 model to allow for wide range of misperception about the information environment (e.g. overconfidence and correlation delusion) as well as the market clearing condition (e.g. understatement of individual impact) and ask when a trading equilibrium can exist.

We show that existence requires either i) the market clearing rule being perceived with (cognitive) noise of arbitrary size, or ii) sufficiently strong misperceptions that lead traders to overestimate the precision of their private information (relative to that of others) or underestimate their market impact. Following i) provides a cognitive foundation for the noise trader approach, while ii) yields a highly tractable linear model of (sufficiently) biased traders. Fixing the bias, a higher number of traders is beneficial for existence, though the economy is typically discontinuous in the countable-trader limit. In the latter case, equilibrium is characterized by limit uncertainty, a property which is satisfied if and only if traders perceive some correlation in their competitors’ information. We also link our existence condition to the volume of informed trade.

Joint work with Elia Sartori.