A Theory of Limited Liquidity and Large Investors Causing Spikes in Stock Market Volatility and Trading Volume
AbstractWe survey a theory of the economic underpinnings of the fat-tailed distributions of a number of financial variables, such as returns and trading volumes. Our theory posits that they have a common origin in the strategic trading behavior of very large financial institutions in a relatively illiquid market. We show how the fat-tailed distribution of fund sizes can indeed generate extreme returns and volumes, even in the absence of fundamental news. Moreover, we are able to replicate the individually different empirical values of the power law exponents for each distribution. Large investors moderate their trades to reduce their price impact; coupled with a concave price impact function, this leads to volumes being more fat-tailed than returns but less fat-tailed than fund sizes. The trades of large institutions offer a unified explanation for apparently disconnected empirical regularities that are otherwise a challenge for economic theory. (JEL: G12, G14, G23) (c) 2007 by the European Economic Association.
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Bibliographic InfoArticle provided by MIT Press in its journal Journal of the European Economic Association.
Volume (Year): 5 (2007)
Issue (Month): 2-3 (04-05)
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Web page: http://www.mitpressjournals.org/jeea
Find related papers by JEL classification:
- 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
- G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
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- Wei-Xing Zhou, 2007. "Universal price impact functions of individual trades in an order-driven market," Papers 0708.3198, arXiv.org, revised Apr 2008.
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