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Higher order expectations, illiquidity, and short-term trading

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  • Cespa, Giovanni

    (IESE Business School)

  • Vives, Xavier

    ()
    (IESE Business School)

Abstract

We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reflect investors' Higher Order Expectations (HOEs) about the two factors that influence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity as liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.

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Bibliographic Info

Paper provided by IESE Business School in its series IESE Research Papers with number D/915.

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Length: 71 pages
Date of creation: 03 Jul 2011
Date of revision:
Handle: RePEc:ebg:iesewp:d-0915

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Postal: IESE Business School, Av Pearson 21, 08034 Barcelona, SPAIN
Web page: http://www.iese.edu/
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Keywords: Expected returns; multiple equilibria; average expectations; over-reliance on public information; beauty contest;

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