Market size matters: A model of excess volatility in large markets

I present a model of excess volatility based on speculation and equilibrium multiplicity generated by the self-fulfilling nature of information aggregation: if individuals trade more on the basis of speculation rather than hedging, then prices reveal more information on payoff risk which justifies less need for hedging. The findings show that multiplicity arises only in large markets. Across multiple equilibria, excess volatility is negatively associated with liquidity, trade volume, and traders׳ welfare. Other findings include: (i) excess volatility increases with payoff volatility and (ii) the asset that attracts more traders is more likely to experience a jump in excess volatility.