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Trading and Liquidity with Limited Cognition

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  • Biais, Bruno
  • Hombert, Johan
  • Weill, Pierre-Olivier

Abstract

We study the reaction of financial 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, reecting 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 Toulouse School of Economics (TSE) in its series TSE Working Papers with number 10-242.

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Date of creation: 07 Dec 2010
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Handle: RePEc:tse:wpaper:24591

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Related research

Keywords: Liquidity shock; Limit-orders; Asset pricing and liquidity; Algorithmic trading; Limited cognition; Sticky plans;

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  1. Ricardo Lagos & Guillaume Rocheteau, 2008. "Liquidity in asset markets with search frictions," Staff Report 408, Federal Reserve Bank of Minneapolis.
  2. Greenwood, Robin, 2005. "Short- and long-term demand curves for stocks: theory and evidence on the dynamics of arbitrage," Journal of Financial Economics, Elsevier, vol. 75(3), pages 607-649, March.
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  6. Pierre-Olivier Weill & Johan Hombert & Bruno Biais, 2012. "Trading and liquidity with limited cognition," 2012 Meeting Papers 118, Society for Economic Dynamics.
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Cited by:
  1. Pierre-Olivier Weill & Johan Hombert & Bruno Biais, 2011. "Trading and Liquidity with Limited Cognition," 2011 Meeting Papers 475, Society for Economic Dynamics.
  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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