By Massimo Pivetti
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Extra resources for An essay on the monetary theory of distribution
Similar intuition can be used to explain the cause of the asset underreaction to extremely bad news. The intuition for the asset price overreaction to the slightly good news is as follows. Note that with noise traders being net sellers of the asset, heuristic traders buy the asset in response to the good news. The reason for heuristic traders buying the asset is that in the case of the signal suggesting good news, a heuristic trader has a larger conditional mean of the asset payoff than a rational trader does.
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.
It is assumed that there are N informed traders. The proportion of informed traders being heuristic traders is denoted as f , where f ∈ (0, 1). After receiving 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 demand for the asset of all traders. Denote the asset price as P and the aggregate demand for the asset of all traders as D. Hence, the asset price is determined by: P = E(θ |D).