Representativeness Heuristic and Asset Price Overreaction or Underreaction to new Information in the Presence of Strategic Interaction

Abstract

This chapter examines how the representativeness heuristic causes the asset price to overreact or underreact to good news or bad news in the presence of strategic interaction. It proves that the representativeness heuristic is capable of causing the asset price overreaction or underreaction to good news or bad news. These results are obtained in a static model of an asset market. In the market, there are three types of traders: rational traders, heuristic traders and noise traders. The asset payoff is unknown to all traders, but rational and heuristic traders receive an informational signal about the asset payoff before any trade takes place. Heuristic traders place too much weight on the current informational signal and not enough weight on their prior information when updating their beliefs about the asset payoff. Rational and heuristic traders are both risk-neutral. Noise traders trade for their liquidity needs. Hence, their demand for the asset is assumed to be random. There is one market maker in the market. The market maker supplies the liquidity to the market. The cost of doing so is assumed to be zero. To maximize their own expected profits, rational and heuristic traders strategically submit their market orders for the asset to the market maker. After observing the aggregate market orders for the asset of all traders, the market maker sets the asset price equal to the expected payoff of the asset conditional on the observed aggregate market orders for the asset of all traders.