Failing to forecast rare events

Bond, P and Dow, J (2021) Failing to forecast rare events. Journal of Financial Economics, 142 (3). pp. 1001-1016. ISSN 0304-405X

Abstract

Do more talented traders prefer to bet on and against rare events or common events? Bets on rare events include out of the money options. Bets against rare events include the carry trade and investment grade bonds. In a model where traders specialize, equilibrium pricing reflects trading ability: A market with more skilled traders has a larger bid ask spread. We show that lower skill traders bet on and against rare events, while higher skill traders bet on and against frequent events, leading to higher bid-ask spreads in common event assets, and reducing financial markets’ ability to predict rare events.