Market Microstructure During Financial Crisis: Dynamics of Informed and Heuristic-Driven Trading

TL;DR

This paper models market microstructure during the 2008 financial crisis, highlighting how informed and heuristic-driven traders behave differently, with heuristic-driven trading remaining constant across market segments and unaffected by size or volume.

Contribution

It introduces a model incorporating heuristic-driven investors with loss-aversion, revealing their persistent presence and disjointness from informed traders during a financial crisis.

Findings

PIN varies significantly during 2008

PH remains constant before and after Lehman Brothers collapse

Heuristic-driven traders are present across all market segments

Abstract

We implement a market microstructure model including informed, uninformed and heuristic-driven investors, which latter behave in line with loss-aversion and mental accounting. We show that the probability of informed trading (PIN) varies significantly during 2008. In contrast, the probability of heuristic-driven trading (PH) remains constant both before and after the collapse of Lehman Brothers. Cross-sectional analysis yields that, unlike PIN, PH is not sensitive to size and volume effects. We show that heuristic-driven traders are universally present in all market segments and their presence is constant over time. Furthermore, we find that heuristic-driven investors and informed traders are disjoint sets.