Discretionary Trading and Asset Price Volatility

Abstract

Against the backdrop of emerging stock markets, this paper examines an asset market where investors behave strategically based on their private information. It is shown that if the investor base expands in the form of more informed traders entering the market, in contrast to the commonly held view, price actually increases. Moreover, if entry is endogenized using transaction costs (brokerage fees), it turns out that the level of participation is stochastic and the market displays excess volatility in price. Informed traders participate in trading only when they believe that the probability of making speculative profits is large and therefore informed trading is discretionary. An extension of the model opens up the possibility of the market displaying informational herding-like behavior despite traders having long trading horizons.