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Strategic Trading and Learning About Liquidity

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  • Harrison Hong
  • Sven Rady

Abstract

Many practitioners point out that the speculative profits of institutional traders are eroded by the difficulty in gauging the price impact of their trades. In this paper, we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know whether the liquidity (¶noise¶) trades are generated from a distribution with high or low variance. Instead, they have to learn about liquidity from past prices and trading volume. Extreme price deviations from forecasts of fundamentals based on public news or low trading volume tend to lead to revisions of beliefs in favor of the low liquidity state. This revision in beliefs implies that strategic trades and market statistics such as informational efficiency are path-dependent on past market outcomes. Our paper has a number of normative implications for practitioners concerned with gauging the potential price impact of their trades.

Suggested Citation

  • Harrison Hong & Sven Rady, 2000. "Strategic Trading and Learning About Liquidity," FMG Discussion Papers dp356, Financial Markets Group.
  • Handle: RePEc:fmg:fmgdps:dp356
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    References listed on IDEAS

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    1. repec:eee:jbfina:v:89:y:2018:i:c:p:209-224 is not listed on IDEAS
    2. Acharya, Viral V. & Johnson, Timothy C., 2007. "Insider trading in credit derivatives," Journal of Financial Economics, Elsevier, vol. 84(1), pages 110-141, April.
    3. Nam, Jouahn & Wang, Jun & Zhang, Ge, 2008. "Strategic trading against retail investors with loss-aversion," International Review of Economics & Finance, Elsevier, vol. 17(1), pages 45-55.

    More about this item

    JEL classification:

    • D40 - Microeconomics - - Market Structure, Pricing, and Design - - - General
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • 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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