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 reflect 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 Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 276.
Date of creation: 09 Mar 2011
Date of revision:
Expected returns; multiple equilibria; average expectations; over-reliance on public information; Beauty Contest.;
Other versions of this item:
- Xavier Vives & Giovanni Cespa, 2011. "Higher Order Expectations, Illiquidity, and Short Term Trading," 2011 Meeting Papers 929, Society for Economic Dynamics.
- 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
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-03-19 (All new papers)
- NEP-CBA-2011-03-19 (Central Banking)
- NEP-CTA-2011-03-19 (Contract Theory & Applications)
- NEP-MST-2011-03-19 (Market Microstructure)
- NEP-UPT-2011-03-19 (Utility Models & Prospect Theory)
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