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Trading and Liquidity with Limited Cognition

  • Pierre-Olivier Weill

    (UCLA)

  • Johan Hombert

    (HEC)

  • Bruno Biais

    (TSE)

We study the reaction of nancial markets to aggregate liquidity shocks when traders face cognition limits. While each nancial institution recovers from the shock at a random time, the trader representing the institution observes this recovery with a delay, re ecting the time it takes to collect and process information about positions, counterparties and risk exposure. Cognition limits lengthen the market price recovery. They also imply that traders who nd that 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 place orders only when they have completed their information processing task.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 475.

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Date of creation: 2011
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Handle: RePEc:red:sed011:475
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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