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Strategic Trading and Learning about Liquidity

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  • Hong, Harrison
  • Rady, Sven

Abstract

Many practitioners point out that the speculative profits of institutional traders arc eroded by the difficulty in gauging the price impact of their trades. In this paper. we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know whether the liquidity ( "noise") trades are generated from a distribution with high or low variance. Instead, they have to learn about liquidity from past prices and trading volume. Extreme price deviations from forecasts of fundamentaIs based on public news or low trading volume tend to lead to revisions of beliefs in favor of the low liquidity state. This revision in beliefs implies that strategie trades and market statistics such as informational efficiency arc path-dependent on past market outcomes. Our paper has a number of normative implications for practitioners concerned with gauging the potential price impact of their trades.

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Bibliographic Info

Paper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 15.

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Date of creation: Jan 2001
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Handle: RePEc:lmu:muenec:15

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References

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  1. Paul A. Gompers & Andrew Metrick, 2001. "Institutional Investors And Equity Prices," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 116(1), pages 229-259, February.
  2. Hausman, J.A. & Lo, A.W. & MacKinlay, A.C., 1991. "An Ordered Probit Analysis of Transaction Stock Prices," Weiss Center Working Papers, Wharton School - Weiss Center for International Financial Research 26-91, Wharton School - Weiss Center for International Financial Research.
  3. Kerry Back & C. Henry Cao & Gregory A. Willard, 2000. "Imperfect Competition among Informed Traders," Journal of Finance, American Finance Association, American Finance Association, vol. 55(5), pages 2117-2155, October.
  4. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, American Finance Association, vol. 51(4), pages 1437-78, September.
  5. Holthausen, Robert W. & Leftwich, Richard W. & Mayers, David, 1990. "Large-block transactions, the speed of response, and temporary and permanent stock-price effects," Journal of Financial Economics, Elsevier, Elsevier, vol. 26(1), pages 71-95, July.
  6. Dimitri Vayanos, 2001. "Strategic trading in a dynamic noisy market," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 447, London School of Economics and Political Science, LSE Library.
  7. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
  8. Seppi, Duane J, 1990. " Equilibrium Block Trading and Asymmetric Information," Journal of Finance, American Finance Association, American Finance Association, vol. 45(1), pages 73-94, March.
  9. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2000. "Commonality in liquidity," Journal of Financial Economics, Elsevier, Elsevier, vol. 56(1), pages 3-28, April.
  10. Foster, F Douglas & Viswanathan, S, 1990. "A Theory of the Interday Variations in Volume, Variance, and Trading Costs in Securities Markets," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 3(4), pages 593-624.
  11. Fama, Eugene F, 1991. " Efficient Capital Markets: II," Journal of Finance, American Finance Association, American Finance Association, vol. 46(5), pages 1575-617, December.
  12. Kraus, Alan & Stoll, Hans R, 1972. "Price Impacts of Block Trading on the New York Stock Exchange," Journal of Finance, American Finance Association, American Finance Association, vol. 27(3), pages 569-88, June.
  13. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
  14. Back, Kerry, 1992. "Insider Trading in Continuous Time," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 5(3), pages 387-409.
  15. Admati, Anat R., 1991. "The informational role of prices : A review essay," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(2), pages 347-361, October.
  16. Forster, Margaret M. & George, Thomas J., 1992. "Anonymity in securities markets," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 2(2), pages 168-206, June.
  17. Kumar, Praveen & Seppi, Duane J, 1994. "Information and Index Arbitrage," The Journal of Business, University of Chicago Press, vol. 67(4), pages 481-509, October.
  18. Bertsimas, Dimitris & Lo, Andrew W., 1998. "Optimal control of execution costs," Journal of Financial Markets, Elsevier, Elsevier, vol. 1(1), pages 1-50, April.
  19. Spiegel, Matthew & Subrahmanyam, Avanidhar, 2000. "Asymmetric Information and News Disclosure Rules," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 9(4), pages 363-403, October.
  20. Chan, Louis K C & Lakonishok, Josef, 1995. " The Behavior of Stock Prices around Institutional Trades," Journal of Finance, American Finance Association, American Finance Association, vol. 50(4), pages 1147-74, September.
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Cited by:
  1. Acharya, Viral V. & Johnson, Timothy C., 2007. "Insider trading in credit derivatives," Journal of Financial Economics, Elsevier, Elsevier, vol. 84(1), pages 110-141, April.
  2. Nam, Jouahn & Wang, Jun & Zhang, Ge, 2008. "Strategic trading against retail investors with loss-aversion," International Review of Economics & Finance, Elsevier, Elsevier, vol. 17(1), pages 45-55.

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