Prospect Theory and Market Liquidity

Abstract

We study equilibrium trading strategies, market liquidity, and price efficiency in an economy in which a fraction of better-informed speculators displays preferences consistent with Kahneman and Tversky’s (1979) Prospect Theory, i.e., loss aversion, risk seeking over losses, and nonlinear and asymmetric probability weighting (in the spirit of Jullien and Salanié, 2000). Loss aversion induces those speculators to trade more cautiously, while risk seeking induces them to trade more aggressively, with their private signals. We demonstrate that the latter effect dominates the former in equilibrium, leading to lower and (because of procyclical subjective loss probabilities) countercyclical adverse selection-based market liquidity and higher price efficiency. We also find that the presence of those speculators affects the extent to which the release of public news about the traded asset’s terminal payoff improves market liquidity and price efficiency and makes such improvement procyclical.