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Trading and liquidity with limited cognition

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  • Pierre-Olivier Weill

    (UCLA)

  • Johan Hombert

    (HEC Paris)

  • Bruno Biais

    (Toulouse School of Economics)

Abstract

We study the reaction of nancial markets to aggregate liquidity shocks when traders face cognition limits. While each financial institution recovers from the shock at a random time, the trader representing the institution observes this recovery with a delay, reflecting the time it takes to collect and process information about positions, counterparties and risk exposure. Cognition limits lengthen the recovery process. They also imply that traders who find 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 only place orders when they have completed their information processing task.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2012 Meeting Papers with number 118.

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Date of creation: 2012
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Handle: RePEc:red:sed012:118

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

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  1. Pierre-Olivier Weill & Johan Hombert & Bruno Biais, 2012. "Trading and liquidity with limited cognition," 2012 Meeting Papers 118, Society for Economic Dynamics.
  2. 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. Pierre-Olivier Weill, 2007. "Leaning Against the Wind," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1329-1354.
  10. Ricardo Lagos & Guillaume Rocheteau, 2007. "Liquidity in asset markets with search frictions," Working Paper 0706, Federal Reserve Bank of Cleveland.
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  15. 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.
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Cited by:
  1. 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.
  2. Pierre-Olivier Weill & Johan Hombert & Bruno Biais, 2012. "Trading and liquidity with limited cognition," 2012 Meeting Papers 118, Society for Economic Dynamics.
  3. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.

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