OPTIMISTIC & PESSIMISTIC TRADING IN FINANCIAL MARKETS

There is an abundant literature in finance on overconfidence, however there exists a different psychological trait well known to financial prac-titioners and psychologists [see Hilton at al. (2004)] which is optimism. This trait has received little attention. Our paper analyses the conse-quences of optimism and pessimism on financial markets. We develop a general model of optimism/pessimism where M unrealistic informed traders and N realistic informed traders trade a risky asset with a com-petitive market maker. Unrealistic traders can (i) misperceive the ex-pected returns of the risky asset (scenario 1) or (ii) in addition to the previous can make a judgmental error on both the volatility of the asset returns and the variance of the noise in his/her private signal (scenario 2). We show, in scenario 1, that optimistic traders purchase more or sell smaller quantities whereas pessimistic traders sell more or purchase smaller quantities than if they were realistic. As market makers cor