Higher Order Expectations, Illiquidity, and Short Term Trading
AbstractWe 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 reect 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 of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.
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Bibliographic InfoPaper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 929.
Date of creation: 2011
Date of revision:
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Other versions of this item:
- Giovanni Cespa & Xavier Vives, 2011. "Higher Order Expectations, Illiquidity, and Short-term Trading," CSEF Working Papers 276, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
- Cespa, Giovanni & Vives, Xavier, 2011. "Higher order expectations, illiquidity, and short-term trading," IESE Research Papers D/915, IESE Business School.
- G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
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