Abstract
I incorporate the level-k thinking solution concept into a simplified (Brummermeier and Pedersen, 2005) predatory trading model to investigate the possibility of arbitraging arbitrageurs. While naive financial predators prey upon a single distressed investor, higher-level thinkers best respond to this and prey upon fellow predators. For some parameter values, sophisticated predators are able to reason their way to the Nash equilibrium strategy, and prices do not oscillate. As parameter values are perturbed, the system undergoes a bifurcation and predators select strategies from a mean-preserving spread of the Nash equilibrium strategy. In these settings, prices display excess volatility and a single shock can send predators into an oscillatory trading frenzy.
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