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Competition,premature trading and excess volatility
Institution:1. International Monetary Fund, 700 19th St., NW, Washington, DC 20431, USA;2. Monash University, Faculty of Business and Economics, Clayton Campus, VIC 3800, Australia;3. Bank of England, Threadneedle St., London EC2R 8AH, United Kingdom;1. School of Economics and Political Science, University of St. Gallen, Switzerland;2. The World Bank and Technical University of Ostrava, Czech Republic;1. Institute of Statistics, Leibniz Universität Hannover, Königsworther Platz 1, 30167 Hannover, Germany;2. Norddeutsche Landesbank Girozentrale, Friedrichswall 10, 30159 Hannover, Germany;3. Touro College Berlin, Am Rupenhorn 5, 14055 Berlin, Germany;1. Institut de statistique, biostatistique et sciences actuarielles (ISBA), Université Catholique de Louvain, Louvain-la-Neuve, Belgium;2. Graduate Institute of Finance, National Taiwan University of Science and Technology, Taiwan;3. Department of Finance, National Taiwan University, Taiwan;1. Centre for Advanced Financial Research and Learning, Reserve Bank of India, India;2. University of Nottingham, GEP, CFCM, United Kingdom;3. CESifo, Germany
Abstract:A substantial body of research suggests that it is difficult to account for all of the volatility of asset prices in terms of news. This paper attempts to explain the excess volatility puzzle as a consequence of competitive interaction between market participants in the presence of noisy information. We develop a model of competitive interaction between market participants in response to unverified information. Our model shows that in the presence of competitive pressures, market participants find it optimal to act prematurely on unverified information. This premature reaction leads to lower total profits and excess market volatility in equilibrium. Our model also shows that the spike in volatility at the closing time of the market can be modelled as a direct consequence of premature trading.
Keywords:Premature trading  Competition  Unverified information  Information uncertainty  Excess volatility
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