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Price informativeness and predictability: how liquidity can help

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  • Lin, William
  • Tsai, Shih-Chuan
  • Sun, David

Abstract

Information asymmetry and liquidity concentration has been widely discussed in literatures. This study shows how liquidity influences not only forecasting performances of term structure estimation, but also information transmission and price adjustment across markets. Our analysis helps understanding how extreme market movements affect one another. This study examines, and provides a rationale for incorporating, liquidity in estimating term structure. Forecasting performance can be greatly enhanced when conditioning on trading liquidity. It reduces information asymmetry in the sense of Easley and O’Hara (2004) and Burlacu, Fontaine and Jimenez-Garces (2007). We adopt a time series forecasting model following Diebold and Li (2006) to compare behavior of forecasted price errors. Our findings indicate that forecasted price errors in markets with less depth would influence those with more. Information asymmetry induces volatile trading first and then price adjustment is transmitted to another market due to insufficient market depth. Cross-market price adjustment could be as much as 21 bps on average. Compared with previous studies, our results establish a valid reason to condition on liquidity when forecasting prices.

Suggested Citation

  • Lin, William & Tsai, Shih-Chuan & Sun, David, 2008. "Price informativeness and predictability: how liquidity can help," MPRA Paper 20226, University Library of Munich, Germany, revised 18 Oct 2009.
    • Handle: RePEc:pra:mprapa:20226
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    References listed on IDEAS

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    More about this item

    Keywords

    Liquidity; Trading Concentration; Information Asymmetry; Information Transmission; Yield Curve Fitting;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications

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