IDEAS home Printed from https://ideas.repec.org/p/ces/ceswps/_3390.html
   My bibliography  Save this paper

Expectations, Liquidity, and Short-term Trading

Author

Listed:
  • Giovanni Cespa
  • Xavier Vives

Abstract

We consider a two-period market with persistent liquidity trading and risk averse privately informed investors who have a one period horizon. With persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors engage in “retrospective” learning to reassess the inference about fundamentals made at the early stage of the trading game. This introduces strategic complementarities in the use of information and can yield two stable equilibria which can be ranked in terms of liquidity, volatility, and informational efficiency. We establish the limits of the beauty contest analogy for financial markets and derive a rich set of implications to explain market anomalies, and empirical regularities.

Suggested Citation

  • Giovanni Cespa & Xavier Vives, 2011. "Expectations, Liquidity, and Short-term Trading," CESifo Working Paper Series 3390, CESifo.
    • Handle: RePEc:ces:ceswps:_3390
    as

    Download full text from publisher

    File URL: https://www.cesifo.org/DocDL/cesifo1_wp3390.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Kristoffer Nimark, 2007. "Dynamic higher order expectations," Economics Working Papers 1118, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 2011.
    2. Bruno Biais & Peter Bossaerts, 1998. "Asset Prices and Trading Volume in a Beauty Contest," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 65(2), pages 307-340.
    3. Dimitri Vayanos & Paul Woolley, 2013. "An Institutional Theory of Momentum and Reversal," The Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1087-1145.
    4. Kathy Yuan, 2005. "Asymmetric Price Movements and Borrowing Constraints: A Rational Expectations Equilibrium Model of Crises, Contagion, and Confusion," Journal of Finance, American Finance Association, vol. 60(1), pages 379-411, February.
    5. John M. Griffin & Jeffrey H. Harris & Selim Topaloglu, 2003. "The Dynamics of Institutional and Individual Trading," Journal of Finance, American Finance Association, vol. 58(6), pages 2285-2320, December.
    6. Cespa, Giovanni, 2002. "Short-term investment and equilibrium multiplicity," European Economic Review, Elsevier, vol. 46(9), pages 1645-1670, October.
    7. Bruno Biais & Peter Bossaerts & Chester Spatt, 2010. "Equilibrium Asset Pricing and Portfolio Choice Under Asymmetric Information," The Review of Financial Studies, Society for Financial Studies, vol. 23(4), pages 1503-1543, April.
    8. Stefan Nagel, 2012. "Evaporating Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 25(7), pages 2005-2039.
    9. Federico Ciliberto & Elie Tamer, 2009. "Market Structure and Multiple Equilibria in Airline Markets," Econometrica, Econometric Society, vol. 77(6), pages 1791-1828, November.
    10. Marco Pagano, 1989. "Endogenous Market Thinness and Stock Price Volatility," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 56(2), pages 269-287.
    11. Goldstein, Itay & Ozdenoren, Emre & Yuan, Kathy, 2013. "Trading frenzies and their impact on real investment," Journal of Financial Economics, Elsevier, vol. 109(2), pages 566-582.
    12. Péter Kondor, 2012. "The More We Know about the Fundamental, the Less We Agree on the Price," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 79(3), pages 1175-1207.
    13. Philippe Bacchetta & Eric Van Wincoop, 2008. "Higher Order Expectations in Asset Pricing," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 837-866, August.
    14. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, vol. 103(4), pages 831-872, August.
    15. repec:bla:jfinan:v:43:y:1988:i:3:p:617-37 is not listed on IDEAS
    16. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
    17. J.J. Heckman & E.E. Leamer (ed.), 2007. "Handbook of Econometrics," Handbook of Econometrics, Elsevier, edition 1, volume 6, number 6b.
    18. Guillermo Llorente & Roni Michaely & Gideon Saar & Jiang Wang, 2002. "Dynamic Volume-Return Relation of Individual Stocks," The Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 1005-1047.
    19. Denis Gromb & Dimitri Vayanos, 2010. "Limits of Arbitrage: The State of the Theory," NBER Working Papers 15821, National Bureau of Economic Research, Inc.
    20. Madhavan, Ananth & Richardson, Matthew & Roomans, Mark, 1997. "Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks," The Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1035-1064.
    21. He, Hua & Wang, Jiang, 1995. "Differential Information and Dynamic Behavior of Stock Trading Volume," The Review of Financial Studies, Society for Financial Studies, vol. 8(4), pages 919-972.
    22. repec:hal:spmain:info:hdl:2441/5rkqqmvrn4tl22s9mc4ao8ocg is not listed on IDEAS
    23. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, vol. 110(2), pages 234-263, June.
    24. Foucault, Thierry & Pagano, Marco & Roell, Ailsa, 2013. "Market Liquidity: Theory, Evidence, and Policy," OUP Catalogue, Oxford University Press, number 9780199936243.
    25. Ackerberg, Daniel & Lanier Benkard, C. & Berry, Steven & Pakes, Ariel, 2007. "Econometric Tools for Analyzing Market Outcomes," Handbook of Econometrics, in: J.J. Heckman & E.E. Leamer (ed.), Handbook of Econometrics, edition 1, volume 6, chapter 63, Elsevier.
    26. Donald P. Morgan & Stavros Peristiani & Vanessa Savino, 2010. "The information value of the stress test and bank opacity," Staff Reports 460, Federal Reserve Bank of New York.
    27. Carole Comerton‐Forde & Terrence Hendershott & Charles M. Jones & Pamela C. Moulton & Mark S. Seasholes, 2010. "Time Variation in Liquidity: The Role of Market‐Maker Inventories and Revenues," Journal of Finance, American Finance Association, vol. 65(1), pages 295-331, February.
    28. Masahiro Watanabe, 2008. "Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry," Journal of Finance, American Finance Association, vol. 63(1), pages 229-272, February.
    29. Dow, James & Gorton, Gary, 1994. "Arbitrage Chains," Journal of Finance, American Finance Association, vol. 49(3), pages 819-849, July.
    30. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
    31. Cristina Cella & Andrew Ellul & Mariassunta Giannetti, 2013. "Investors' Horizons and the Amplification of Market Shocks," The Review of Financial Studies, Society for Financial Studies, vol. 26(7), pages 1607-1648.
    32. Giovanni Cespa & Xavier Vives, 2012. "Dynamic Trading and Asset Prices: Keynes vs. Hayek," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 79(2), pages 539-580.
    33. Vives, Xavier, 1995. "Short-Term Investment and the Informational Efficiency of the Market," The Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 125-160.
    34. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    35. repec:bla:jfinan:v:53:y:1998:i:5:p:1589-1622 is not listed on IDEAS
    36. repec:bla:jfinan:v:53:y:1998:i:6:p:1839-1885 is not listed on IDEAS
    37. Alfred Galichon & Marc Henry, 2011. "Set Identification in Models with Multiple Equilibria," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 78(4), pages 1264-1298.
    38. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
    39. Grossman, S.J. & Miller, M.H., 1988. "Liquidity And Market Structure," Papers 88, Princeton, Department of Economics - Financial Research Center.
    40. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
    41. Chen, Qi & Goldstein, Itay & Jiang, Wei, 2010. "Payoff complementarities and financial fragility: Evidence from mutual fund outflows," Journal of Financial Economics, Elsevier, vol. 97(2), pages 239-262, August.
    42. Liyan Yang & Itay Goldstein, 2012. "Information Diversity and Market Efficiency Spirals," 2012 Meeting Papers 349, Society for Economic Dynamics.
    43. Chordia, Tarun & Subrahmanyam, Avanidhar, 2004. "Order imbalance and individual stock returns: Theory and evidence," Journal of Financial Economics, Elsevier, vol. 72(3), pages 485-518, June.
    44. Federico Echenique & Ivana Komunjer, 2009. "Testing Models With Multiple Equilibria by Quantile Methods," Econometrica, Econometric Society, vol. 77(4), pages 1281-1297, July.
    45. Andrew G. Haldane & Richard Davies, 2012. "The Short Long," Chapters in SUERF Studies, SUERF - The European Money and Finance Forum.
    46. Coval, Joshua & Stafford, Erik, 2007. "Asset fire sales (and purchases) in equity markets," Journal of Financial Economics, Elsevier, vol. 86(2), pages 479-512, November.
    47. Giovanni Cespa, 2005. "Giffen goods and market making," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 983-997, June.
    48. Dong Lou, 2012. "A Flow-Based Explanation for Return Predictability," The Review of Financial Studies, Society for Financial Studies, vol. 25(12), pages 3457-3489.
    49. Philip Bond & Itay Goldstein & Edward Simpson Prescott, 2010. "Market-Based Corrective Actions," The Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 781-820, February.
    50. Huang, Roger D & Stoll, Hans R, 1997. "The Components of the Bid-Ask Spread: A General Approach," The Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 995-1034.
    51. repec:hal:wpspec:info:hdl:2441/5rkqqmvrn4tl22s9mc4ao8ocg is not listed on IDEAS
    52. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," The Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
    53. Chordia, Tarun & Roll, Richard & Subrahmanyam, Avanidhar, 2008. "Liquidity and market efficiency," Journal of Financial Economics, Elsevier, vol. 87(2), pages 249-268, February.
    54. Harrison Hong & Jeremy C. Stein, 2007. "Disagreement and the Stock Market," Journal of Economic Perspectives, American Economic Association, vol. 21(2), pages 109-128, Spring.
    55. Froot, Kenneth A & Scharftstein, David S & Stein, Jeremy C, 1992. "Herd on the Street: Informational Inefficiencies in a Market with Short-Term Speculation," Journal of Finance, American Finance Association, vol. 47(4), pages 1461-1484, September.
    56. Harrison Hong & Jeremy C. Stein, 1999. "A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets," Journal of Finance, American Finance Association, vol. 54(6), pages 2143-2184, December.
    57. Jayant Vivek Ganguli & Liyan Yang, 2009. "Complementarities, Multiplicity, and Supply Information," Journal of the European Economic Association, MIT Press, vol. 7(1), pages 90-115, March.
    58. Henker, Thomas & Wang, Jian-Xin, 2006. "On the importance of timing specifications in market microstructure research," Journal of Financial Markets, Elsevier, vol. 9(2), pages 162-179, May.
    59. J.J. Heckman & E.E. Leamer (ed.), 2007. "Handbook of Econometrics," Handbook of Econometrics, Elsevier, edition 1, volume 6, number 6a.
    60. Spiegel, Matthew, 1998. "Stock Price Volatility in a Multiple Security Overlapping Generations Model," The Review of Financial Studies, Society for Financial Studies, vol. 11(2), pages 419-447.
    61. Verardo, Michela, 2009. "Heterogeneous Beliefs and Momentum Profits," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 44(4), pages 795-822, August.
    62. Jovanovic, Boyan, 1989. "Observable Implications of Models with Multiple Equilibria," Econometrica, Econometric Society, vol. 57(6), pages 1431-1437, November.
    63. De Bondt, Werner F M & Thaler, Richard, 1985. "Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
    64. Snehal Banerjee & Ron Kaniel & Ilan Kremer, 2009. "Price Drift as an Outcome of Differences in Higher-Order Beliefs," The Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3707-3734, September.
    65. John Y. Campbell & Albert S. Kyle, 1993. "Smart Money, Noise Trading and Stock Price Behaviour," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(1), pages 1-34.
    66. Emre Ozdenoren & Kathy Yuan, 2008. "Feedback Effects and Asset Prices," Journal of Finance, American Finance Association, vol. 63(4), pages 1939-1975, August.
    67. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, August.
    68. Snehal Banerjee, 2011. "Learning from Prices and the Dispersion in Beliefs," The Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 3025-3068.
    69. Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
    70. repec:oup:rfinst:v:25:y::i:12:p:3457-3489 is not listed on IDEAS
    71. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    72. Bengt Holmstrom & Joan Ricart i Costa, 1986. "Managerial Incentives and Capital Management," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 101(4), pages 835-860.
    73. Denis Gromb & Dimitri Vayanos, 2010. "Limits of Arbitrage," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 251-275, December.
    74. Shleifer, Andrei & Vishny, Robert W, 1990. "Equilibrium Short Horizons of Investors and Firms," American Economic Review, American Economic Association, vol. 80(2), pages 148-153, May.
    75. Darrell Duffie, 2010. "Presidential Address: Asset Price Dynamics with Slow‐Moving Capital," Journal of Finance, American Finance Association, vol. 65(4), pages 1237-1267, August.
    76. Jegadeesh, Narasimhan & Titman, Sheridan, 1993. "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency," Journal of Finance, American Finance Association, vol. 48(1), pages 65-91, March.
    77. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-657, May.
    78. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," The Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Giovanni Cespa & Xavier Vives, 2015. "The Beauty Contest and Short-Term Trading," Journal of Finance, American Finance Association, vol. 70(5), pages 2099-2154, October.
    2. Cespa, Giovanni & Vives, Xavier, 2011. "Higher order expectations, illiquidity, and short-term trading," IESE Research Papers D/915, IESE Business School.
    3. Peress, Joel & Schmidt, Daniel, 2021. "Noise traders incarnate: Describing a realistic noise trading process," Journal of Financial Markets, Elsevier, vol. 54(C).
    4. Giovanni Cespa & Xavier Vives, 2012. "Dynamic Trading and Asset Prices: Keynes vs. Hayek," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 79(2), pages 539-580.
    5. Andrei, Daniel & Cujean, Julien, 2017. "Information percolation, momentum and reversal," Journal of Financial Economics, Elsevier, vol. 123(3), pages 617-645.
    6. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    7. Makarov, Igor & Rytchkov, Oleg, 2012. "Forecasting the forecasts of others: Implications for asset pricing," Journal of Economic Theory, Elsevier, vol. 147(3), pages 941-966.
    8. Pavan, Alessandro & Vives, Xavier, 2015. "Information, Coordination, and Market Frictions: An Introduction," Journal of Economic Theory, Elsevier, vol. 158(PB), pages 407-426.
    9. Albuquerque, Rui & Miao, Jianjun, 2014. "Advance information and asset prices," Journal of Economic Theory, Elsevier, vol. 149(C), pages 236-275.
    10. Angeletos, G.-M. & Lian, C., 2016. "Incomplete Information in Macroeconomics," Handbook of Macroeconomics, in: J. B. Taylor & Harald Uhlig (ed.), Handbook of Macroeconomics, edition 1, volume 2, chapter 0, pages 1065-1240, Elsevier.
    11. Blankespoor, Elizabeth & deHaan, Ed & Marinovic, Iván, 2020. "Disclosure processing costs, investors’ information choice, and equity market outcomes: A review," Journal of Accounting and Economics, Elsevier, vol. 70(2).
    12. Wei Xiong, 2013. "Bubbles, Crises, and Heterogeneous Beliefs," NBER Working Papers 18905, National Bureau of Economic Research, Inc.
    13. Adam Zaremba & Jacob Koby Shemer, 2018. "Price-Based Investment Strategies," Springer Books, Springer, number 978-3-319-91530-2, February.
    14. Jordi Mondria & Xavier Vives & Liyan Yang, 2022. "Costly Interpretation of Asset Prices," Management Science, INFORMS, vol. 68(1), pages 52-74, January.
    15. Zhifeng Cai, 2020. "Dynamic information acquisition and time-varying uncertainty," Departmental Working Papers 202002, Rutgers University, Department of Economics.
    16. Elias Albagli & Christian Hellwig & Aleh Tsyvinski, 2011. "A Theory of Asset Prices Based on Heterogeneous Information," Cowles Foundation Discussion Papers 1827, Cowles Foundation for Research in Economics, Yale University.
    17. Ledenyov, Dimitri O. & Ledenyov, Viktor O., 2015. "Wave function method to forecast foreign currencies exchange rates at ultra high frequency electronic trading in foreign currencies exchange markets," MPRA Paper 67470, University Library of Munich, Germany.
    18. Tom Marty & Bruce Vanstone & Tobias Hahn, 2020. "News media analytics in finance: a survey," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 60(2), pages 1385-1434, June.
    19. Marco Ottaviani & Peter Norman Sørensen, 2015. "Price Reaction to Information with Heterogeneous Beliefs and Wealth Effects: Underreaction, Momentum, and Reversal," American Economic Review, American Economic Association, vol. 105(1), pages 1-34, January.
    20. Craig W. Holden & Stacey Jacobsen & Avanidhar Subrahmanyam, 2014. "The Empirical Analysis of Liquidity," Foundations and Trends(R) in Finance, now publishers, vol. 8(4), pages 263-365, December.

    More about this item

    Keywords

    price speculation; multiple equilibria; average expectations; public information; momentum and reversal; Beauty Contest;
    All these keywords.

    JEL classification:

    • 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

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ces:ceswps:_3390. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Klaus Wohlrabe (email available below). General contact details of provider: https://edirc.repec.org/data/cesifde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.