School of Business

Divergent Expectations

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Description: Investors who have the same information and interpret it differently are said to have divergent (as distinct from homogeneous) expectations. Financial economists generally frown on the divergent expectations assumption, even though it is critically important in describing reality. The idea of divergent expectations paves the way to understanding price and quantity discovery as major functions of a marketplace, and goes to the heart of important questions: What drives trading, and why does market structure matter? Many issues concerning market structure and market structure regulation should be analyzed in a divergent or heterogeneous expectations context, which has implications for market participants and public policy. We benefit from paying more attention to how asset managers behave as well as the exchange FIFO protocol for trading. We identify trading costs for several categories of market participants. The trading costs on the BAX are much less than the minimum contract tick value and are similar to the costs estimated for Eurodollar futures on the CME; however, transaction costs on SXF are much higher than the contract's minimum tick value and exceed those estimated for the CME S&P 500 index futures contracts. Transaction costs and measures of trading activity do not appear to be correlated.
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