Strategic trading and learning about liquidity
AbstractWe develop a multi-period model of strategic trading in an asset market where traders are uncertain about market liquidity. In our model, informed traders strategically trade against competitive market makers to exploit their short-lived private information. Unlike market makers, informed traders do not know whether the liquidity ('noise') trades are generated from a distribution with high or low variance. Instead, informed traders have to learn about liquidity from past prices. We find the following. (1) Prices that deviate markedly from the forecast of terminal asset value based on public news tend to lead to revisions of informed traders' beliefs in favour of the low liquidity state. (2) This revision in beliefs results in less aggressive trading on private information by informed traders. (3) In turn, informational efficiency and trading volume are dependent on the path of prices. (4) Moreover, learning about liquidity also has interesting effects on the unconditional properties of optimal strategic trading policies.
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Bibliographic InfoArticle provided by Elsevier in its journal Journal of Financial Markets.
Volume (Year): 5 (2002)
Issue (Month): 4 (October)
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Web page: http://www.elsevier.com/locate/finmar
Other versions of this item:
- Hong, Harrison G & Rady, Sven, 2000. "Strategic Trading And Learning About Liquidity," CEPR Discussion Papers 2416, C.E.P.R. Discussion Papers.
- Harrison Hong & Sven Rady, 2000. "Strategic Trading and Learning About Liquidity," FMG Discussion Papers dp356, Financial Markets Group.
- Hong, Harrison & Rady, Sven, 2001. "Strategic Trading and Learning about Liquidity," Discussion Papers in Economics 15, University of Munich, Department of Economics.
- Harrison Hong & Sven Rady, 2000. "Strategic Trading and Learning about Liquidity," Econometric Society World Congress 2000 Contributed Papers 1351, Econometric Society.
- D40 - Microeconomics - - Market Structure and Pricing - - - General
- D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
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