When Market Illiquidity Generates Volumes
AbstractWe develop a model of the daily return-volume relationship which incorporates information and liquidity shocks. First, we distinguish between two trading strategies, information-based and liquidity-based trading and suggest that their respective impacts on returns and volume should be modeled differently. Second, we integrate the microstructure setting of Grossman-Miller (1988) with the information flow perspective of Tauchen-Pitts (1983) and derive a modified MDH model with two latent factors related to information and liquidity. Our model explains how the liquidity frictions can increase the daily traded volume, in the presence of liquidity arbitragers. Finally, we propose a stock-specific liquidity measure using daily return and volume observations of FTSE100 stocks.
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Date of creation: 2010
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Volatility-volume relationship; mixture of distribution hypothesis; liquidity shocks; informed trading; liquidity arbitrage;
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