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Financial Markets and Correlation Neglect

Wang, L. Financial Markets and Correlation Neglect. .

Abstract

In this paper, I examine the impact of “correlation neglect” in a financial market, where naive traders neglect the correlation between signal errors. I develop a model including both naiveand rational traders. I find that the impact of naive traders on market quality, measured by liquidity and mispricing risk, depends on whether information is costly or not. If information acquisition is free of charge and correlation between signal errors is relatively low, mispricing risk decreases in the mass of naive traders; but when correlation is large enough, mispricing risk is U-shaped. Conversely, when information acquisition is costly, market liquidity deteriorates and mispricing risk increases in the mass of naive traders given that their mass is not too large to drive all informed rational traders out of the market; but market quality can improve afterwards after informed rational traders are entirely crowded out, depending on the correlation and the mass of naive traders.

Publication Type: Monograph (Working Paper)
Subjects: H Social Sciences > HG Finance
Departments: Bayes Business School
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