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Price Discovery in the Presence of Boundedly Rational Agents

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Keiber, Karl Ludwig

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Abstract In this paper we propose a sequential model of security trading which, compared to existing models, is extended along the notions of Simon (1955), Rubinstein (1998), and Odean (1999) by adding boundedly rational traders. Our results indicate that both momentum and mean-reversion in asset prices can be attributed to the presence of agents who are subject to systematic errors in the process of forecasting the liquidation value of a risky security. The length of the momentum period is inversely related to both the amount of information-based trading in the market and the rate at which asset specific information is learned by boundedly rational agents. Furthermore, the model allows explicitly to establish a link between the component of the bid-ask spread that can be explained by bounded rationality and both momentum and reversal.
Classification National Economy; Economic Statistics, Econometrics, Business Informatics
Free Keywords Interest Rate Modelling; LIBOR Market Models; Derivatives Pricing; American Options
Publication Year 2008
Page/Pages p. 235-249
Journal Quantitative Finance, 8 (2008) 3
Status Postprint; reviewed
Licence PEER Licence Agreement (applicable only to documents from PEER project)