Over the coming months the CFP will be highlighting the Smith finance faculty’s latest research. Biographical and contact information on the faculty members can be found here. Please direct any questions about this series to the CFP’s assistant director, Kristen Fanarakis.
Smooth Trading With Overconfidence and Market Power
In financial markets, both permanent and temporary price impacts are extremely important when traders design their optimal execution strategies for liquidations of existing positions. When large traders in financial markets seek to profit from perishable private information, they face a fundamental trade-off. On the one hand, they want to trade slowly, to reduce their own temporary price impact costs resulting from adverse selection. On the other hand, they want to trade quickly, before the permanent price impact of competitors trading on similar information makes profit opportunities go away. The temporary price impact makes trading a given quantity over a shorter horizon more expensive than trading the same quantity over a longer horizon; as the market offers no instantaneous liquidity for block trades.
This model explains well the “flash crash” of May 6, 2010 and how market prices would respond to a gigantic order executed much faster than the market expects orders of such size to be executed. It provides a realistic description of trading by large asset managers, who seek out risks to exploit private information about individual stocks, often limit their trading acquiring positions over days, weeks, or even months.
LINK TO PAPER:
We describe a symmetric continuous-time model of trading among relatively overconfident, oligopolistic informed traders with exponential utility. Traders agree to disagree about the precisions of their continuous flows of Gaussian private information. The price depends on a trader’s inventory (permanent price impact) and the derivative of a trader’s inventory (temporary price impact). More disagreement makes the market more liquid; without enough disagreement, there is no trade. Target inventories mean-revert at the same rate as private signals. Actual inventories smoothly adjust toward target inventories at an endogenous rate which increases with disagreement. Faster-than-equilibrium trading generates “flash crashes” by increasing temporary price impact. A “Keynesian beauty contest” dampens price fluctuations.