Rational-expectations whiplash

Efstathios Avdis, Efstathios Avdis, Masahiro Watanabe, Efstathios Avdis, Masahiro Watanabe - Mar 15, 2017

We present a financial market with investors who have nested private information. Small perturbations of price informativeness, originating from fat-finger errors or algorithmic glitches of well-informed investors, can trigger an oscillating shock throughout the economy that destabilizes the feedback loop between prices and expectations. Moreover, decreasing the volatility of liquidity trading makes the equilibrium less stable. We investigate what the distribution of informed investors implies for equilibrium stability and for the risk premium of the asset. We find that different investor distributions have different implications, depending on whether adverse-selection or risk-sharing effects dominate in the economy.
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