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Expectations, Liquidity, and Short-term Trading

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  • Cespa, Giovanni
  • Vives, Xavier

Abstract

In a market with short term agents and heterogeneous information, when liquidity trading displays persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors exploit a private learning channel to infer the demand of liquidity traders from the order flow to anticipate the evolution of the future aggregate demand for the stock. This yields multiple equilibria which can be ranked in terms of liquidity and informational effciency. Our results have implications for the impact of High Frequency Trading (HFT) on market quality and for the role of average expectations inasset pricing. We show that with persistence HFT can enhance informational efficiency and liquidity -- though creating an unstable equilibrium. In the equilibrium with high (low) informational effciency, prices are closer to (farther away from) fundamentals compared to consensus estimates.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 8303.

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Date of creation: Mar 2011
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Handle: RePEc:cpr:ceprdp:8303

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Related research

Keywords: Average expectations; Beauty Contest; Expected returns; High Frequency Trading; momentum and reversal; Multiple equilibria; Over-reliance on public information; price crash;

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References

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  1. David Easley & Robert F. Engle & Maureen O'Hara & Liuren Wu, 2008. "Time-Varying Arrival Rates of Informed and Uninformed Trades," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 6(2), pages 171-207, Spring.
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  14. Amihud, Yakov & Mendelson, Haim & Pedersen, Lasse Heje, 2005. "Liquidity and Asset Prices," MPRA Paper 24768, University Library of Munich, Germany.
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  17. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
  18. Péter Kondor, 2009. "The more we know, the less we agree: Higher-order expectations and public announcements," 2009 Meeting Papers 1018, Society for Economic Dynamics.
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