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Trading and Liquidity with Limited Cognition

Author

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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.

Suggested Citation

  • Biais, Bruno & Hombert, Johan & Weill, Pierre-Olivier, 2010. "Trading and Liquidity with Limited Cognition," IDEI Working Papers 665, Institut d'Économie Industrielle (IDEI), Toulouse.
  • Handle: RePEc:ide:wpaper:24162
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, Elsevier.
    2. Dimitri Vayanos & Jiang Wang, 2012. "Market Liquidity - Theory and Empirical Evidence," FMG Discussion Papers dp709, Financial Markets Group.
    3. George J. Jiang & Ingrid Lo & Giorgio Valente, 2014. "High-Frequency Trading around Macroeconomic News Announcements: Evidence from the U.S. Treasury Market," Staff Working Papers 14-56, Bank of Canada.
    4. repec:eee:finmar:v:33:y:2017:i:c:p:1-21 is not listed on IDEAS
    5. 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.

    More about this item

    Keywords

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

    JEL classification:

    • 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

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