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Equilibrium Pricing and Trading Volume under Preference Uncertainty

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

Information collection, processing and dissemination financial institutions is challenging. This can delay the observation by traders of the exact capital charges and constraints of their institution. During this delay, traders face preference uncertainty. In this context, we study optimal trading strategies and equilibrium prices in a continuous centralized market. We focus on liquidity shocks, during which preference uncertainty is likely to matter most. Preference uncertainty generates allocative ineficiency, but need not reduce prices. Traders progressively learning about the preferences of their institution conduct round-trip trades, which generate excess volume relative to the frictionless market. In a cross section of liquidity shocks, the initial price drop is positively correlated with total trading volume. Across traders, the number of round-trips is negatively correlated with trading profi ts and average inventory.

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Paper provided by Institut d'Économie Industrielle (IDEI), Toulouse in its series IDEI Working Papers with number 787.

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Date of creation: 16 Jul 2013
Date of revision: Dec 2013
Publication status: Published in The Review of Economic Studies, vol.�81, n°4, 2014, p.�1401-1437.
Handle: RePEc:ide:wpaper:27434
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  1. Ricardo Lagos & Gara Afonson, 2011. "Trade Dynamics in the Market for Federal Funds," 2011 Meeting Papers 314, Society for Economic Dynamics.
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