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Trading and Liquidity with Limited Cognition

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Author Info

  • Pierre-Olivier Weill

    (UCLA)

  • Johan Hombert

    (HEC)

  • Bruno Biais

    (TSE)

Abstract

We study the reaction of nancial markets to aggregate liquidity shocks when traders face cognition limits. While each nancial institution recovers from the shock at a random time, the trader representing the institution observes this recovery with a delay, re ecting the time it takes to collect and process information about positions, counterparties and risk exposure. Cognition limits lengthen the market price recovery. They also imply that traders who nd that their institution has not yet recovered from the shock place market sell orders, and then progressively buy back at relatively low prices, while simultaneously placing limit orders to sell later when the price will have recovered. This generates round trip trades, which raise trading volume. We compare the case where algorithms enable traders to implement this strategy to that where traders can place orders only when they have completed their information processing task.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 475.

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Date of creation: 2011
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Handle: RePEc:red:sed011:475

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Keywords: Liquidity shock; limit-orders; asset pricing;

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References

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  1. Thierry Foucault & Ohad Kadan & Eugene Kandel, 2005. "Limit Order Book as a Market for Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 18(4), pages 1171-1217.
  2. Bruno Biais & Johan Hombert & Pierre-Olivier Weill, 2010. "Trading and Liquidity with Limited Cognition," NBER Working Papers 16628, National Bureau of Economic Research, Inc.
  3. N. Gregory Mankiw & Ricardo Reis, 2001. "Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve," Harvard Institute of Economic Research Working Papers 1922, Harvard - Institute of Economic Research.
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  9. Parlour, Christine A, 1998. "Price Dynamics in Limit Order Markets," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 789-816.
  10. Ronald L. Goettler & Christine A. Parlour & Uday Rajan, 2005. "Equilibrium in a Dynamic Limit Order Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2149-2192, October.
  11. Grossman, Sanford J & Miller, Merton H, 1988. " Liquidity and Market Structure," Journal of Finance, American Finance Association, vol. 43(3), pages 617-37, July.
  12. Pierre-Olivier Weill, 2004. "Leaning against the wind," 2004 Meeting Papers 382, Society for Economic Dynamics.
  13. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity Premium Puzzle," Harvard Institute of Economic Research Working Papers 1947, Harvard - Institute of Economic Research.
  14. Goettler, Ronald L. & Parlour, Christine A. & Rajan, Uday, 2009. "Informed traders and limit order markets," Journal of Financial Economics, Elsevier, vol. 93(1), pages 67-87, July.
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Cited by:
  1. Biais, Bruno & Hombert, Johan & Weill, Pierre-Olivier, 2010. "Trading and Liquidity with Limited Cognition," IDEI Working Papers 665, Institut d'Économie Industrielle (IDEI), Toulouse.
  2. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity — Theory and Empirical Evidence," NBER Working Papers 18251, National Bureau of Economic Research, Inc.
  3. Sarah Draus & Mark van Achter, 2012. "Circuit Breakers and Market Runs," CSEF Working Papers 313, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.

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