Price distortions under coarse reasoning with frequent trade

Jakub Steiner, Colin Stewart

Research output: Contribution to journalArticlepeer-review

Abstract

We study the effect of frequent trading opportunities and categorization on pricing of a risky asset. Frequent opportunities to trade can lead to large distortions in prices if some agents forecast future prices using a simplified model of the world that fails to distinguish between some states. In the limit as the period length vanishes, these distortions take a particular form: the price must be the same in any two states that a positive mass of agents categorize together. Price distortions therefore tend to be large when different agents categorize states in different ways, even if each individual’s categorization is not very coarse.
Original languageEnglish
Pages (from-to)574-595
Number of pages31
JournalJournal of Economic Theory
Volume159
Early online date17 Jul 2015
DOIs
Publication statusPublished - 30 Sep 2015

Keywords

  • categorization
  • bounded rationality
  • prices

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