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Price informativeness and predictability: how liquidity can help

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

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.

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File URL: http://mpra.ub.uni-muenchen.de/20226/1/MPRA_paper_20226.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 20226.

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Date of creation: 25 Feb 2008
Date of revision: 18 Oct 2009
Publication status: Published in Applied Economics 43.17(2011): pp. 2199-2217
Handle: RePEc:pra:mprapa:20226
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Web page: http://mpra.ub.uni-muenchen.de

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  1. David Easley & Soeren Hvidkjaer & Maureen O'Hara, 2002. "Is Information Risk a Determinant of Asset Returns?," Journal of Finance, American Finance Association, vol. 57(5), pages 2185-2221, October.
  2. T. Clifton Green, 2004. "Economic News and the Impact of Trading on Bond Prices," Journal of Finance, American Finance Association, vol. 59(3), pages 1201-1234, 06.
  3. Bolder, David & Streliski, David, 1999. "Yield Curve Modelling at the Bank of Canada," Technical Reports 84, Bank of Canada.
  4. Edwin J. Elton & T. Clifton Green, 1998. "Tax and Liquidity Effects in Pricing Government Bonds," Journal of Finance, American Finance Association, vol. 53(5), pages 1533-1562, October.
  5. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
  6. 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.
  7. Favero, Carlo A. & Niu, Linlin & Sala, Luca, 2007. "Term Structure Forecasting: No-Arbitrage Restrictions vs Large Information Set," CEPR Discussion Papers 6206, C.E.P.R. Discussion Papers.
  8. Sarig, Oded & Warga, Arthur, 1989. "Bond Price Data and Bond Market Liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 367-378, September.
  9. Diaz, Antonio & Merrick, John Jr. & Navarro, Eliseo, 2006. "Spanish Treasury bond market liquidity and volatility pre- and post-European Monetary Union," Journal of Banking & Finance, Elsevier, vol. 30(4), pages 1309-1332, April.
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