nep-mst New Economics Papers
on Market Microstructure
Issue of 2015‒06‒05
two papers chosen by
Thanos Verousis

  1. Financial Markets where Traders Neglect the Informational Content of Prices By Eyster, Erik; Rabin, Matthew; Vayanos, Dimitri
  2. A Practical Approach to Financial Crisis Indicators Based on Random Matrices By Antoine Kornprobst; Raphael Douady

  1. By: Eyster, Erik; Rabin, Matthew; Vayanos, Dimitri
    Abstract: We present a model of a financial market where some traders are ``cursed'' when choosing how much to invest in a risky asset, failing to fully take into account what prices convey about others' private information. Cursed traders put more weight on their private signals than rational traders. But because they neglect that the price encodes other traders' information, prices depend less on private signals and more on public signals than rational-expectation-equilibrium (REE) prices. Markets comprised entirely of cursed traders generate more trade than those comprised entirely of rationals; mixed markets can generate even more trade, as rationals employ momentum-trading strategies to exploit cursed traders. We contrast our results to other models of departures from REE and show that per-trader volume with cursed traders increases when the market becomes large, while natural forms of overconfidence predict that volume should converge to zero.
    Keywords: behavioral finance; cursedness; financial markets; overconfidence; return predictability; trading volume
    JEL: D53 D84 G02 G11 G12 G14
    Date: 2015–05
  2. By: Antoine Kornprobst; Raphael Douady
    Abstract: The aim of this work is to build financial crisis indicators based on market data time series. After choosing an optimal size for a rolling window, the market data is seen every trading day as a random matrix from which a covariance and correlation matrix is obtained. Our indicators deal with the spectral properties of these covariance and correlation matrices. Our basic financial intuition is that correlation and volatility are like the heartbeat of the financial market: when correlations between asset prices increase or develop abnormal patterns, when volatility starts to increase, then a crisis event might be around the corner. Our indicators will be mainly of two types. The first one is based on the Hellinger distance, computed between the distribution of the eigenvalues of the empirical covariance matrix and the distribution of the eigenvalues of a reference covariance matrix. As reference distributions we will use the theoretical Marchenko Pastur distribution and, mainly, simulated ones using a random matrix of the same size as the empirical rolling matrix and constituted of Gaussian or Student-t coefficients with some simulated correlations. The idea behind this first type of indicators is that when the empirical distribution of the spectrum of the covariance matrix is deviating from the reference in the sense of Hellinger, then a crisis may be forthcoming. The second type of indicators is based on the study of the spectral radius and the trace of the covariance and correlation matrices as a mean to directly study the volatility and correlations inside the market. The idea behind the second type of indicators is the fact that large eigenvalues are a sign of dynamic instability.
    Date: 2015–06

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