Higher Order Expectations, Illiquidity, and Short-term Trading
We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reflect investors' Higher Order Expectations (HOEs) about the two factors that influence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.
|Date of creation:||09 Mar 2011|
|Date of revision:|
|Contact details of provider:|| Postal: |
Phone: +39 081 - 675372
Fax: +39 081 - 675372
Web page: http://www.csef.it/
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- James Dow & Gary Gorton, .
Rodney L. White Center for Financial Research Working Papers
6-93, Wharton School Rodney L. White Center for Financial Research.
- James Dow & Gary Gorton, 1993. "Arbitrage Chains," NBER Working Papers 4314, National Bureau of Economic Research, Inc.
- James Dow & Gary Gorton, . "Arbitrage Chains," Rodney L. White Center for Financial Research Working Papers 06-93, Wharton School Rodney L. White Center for Financial Research.
- James Dow & Gary Gorton, 1993. "Arbitrage Chains," CEPR Financial Markets Paper 0035, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
- Tobias Adrian & Hyun Song Shin, 2008.
"Liquidity and leverage,"
328, Federal Reserve Bank of New York.
- Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
- Philippe BACCHETTA & Eric VAN WINCOOP, 2004.
"Higher Order Expectations in Asset Pricing,"
FAME Research Paper Series
rp110, International Center for Financial Asset Management and Engineering.
- Bacchetta, Philippe & van Wincoop, Eric, 2008. "Higher Order Expectations in Asset Pricing," CEPR Discussion Papers 6648, C.E.P.R. Discussion Papers.
- Philippe Bacchetta & Eric van Wincoop, 2004. "Higher Order Expectations in Asset Pricing," Working Papers 04.03, Swiss National Bank, Study Center Gerzensee.
- Acharya, Viral V & Pedersen, Lasse Heje, 2004.
"Asset Pricing with Liquidity Risk,"
CEPR Discussion Papers
4718, C.E.P.R. Discussion Papers.
- Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
- Stephen Morris & Hyun Song Shin, 2002. "Social Value of Public Information," American Economic Review, American Economic Association, vol. 92(5), pages 1521-1534, December.
- De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July.
- Amihud, Yakov & Mendelson, Haim & Pedersen, Lasse Heje, 2005.
"Liquidity and Asset Prices,"
24768, University Library of Munich, Germany.
- Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
- Kristoffer Nimark, 2007.
"Dynamic higher order expectations,"
Economics Working Papers
1118, Department of Economics and Business, Universitat Pompeu Fabra, revised Mar 2011.
- Grossman, S.J. & Miller, M.H., 1988.
"Liquidity And Market Structure,"
88, Princeton, Department of Economics - Financial Research Center.
- Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
- Cespa, Giovanni, 2002.
"Short-term investment and equilibrium multiplicity,"
European Economic Review,
Elsevier, vol. 46(9), pages 1645-1670, October.
- Giovanni Cespa, 2000. "Short-term investment and equilibrium multiplicity," Economics Working Papers 520, Department of Economics and Business, Universitat Pompeu Fabra, revised Jun 2002.
- Marco Ottaviani & Peter Norman Sørensen, 2009. "Aggregation of Information and Beliefs: Asset Pricing Lessons from Prediction Markets," Discussion Papers 09-14, University of Copenhagen. Department of Economics.
- Péter Kondor, 2009. "The more we know, the less we agree: Higher-order expectations and public announcements," 2009 Meeting Papers 1018, Society for Economic Dynamics.
- David Easley & Robert F. Engle & Maureen O'Hara & Liuren Wu, 2002.
"Time-Varying Arrival Rates of Informed and Uninformed Trades,"
- David Easley & Robert F. Engle & Maureen O'Hara & Liuren Wu, 2008. "Time-Varying Arrival Rates of Informed and Uninformed Trades," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 6(2), pages 171-207, Spring.
- Brennan, Michael J. & Subrahmanyam, Avanidhar, 1996. "Market microstructure and asset pricing: On the compensation for illiquidity in stock returns," Journal of Financial Economics, Elsevier, vol. 41(3), pages 441-464, July.
- Dimitri Vayanos, 1998.
"Transaction costs and asset prices : a dynamic equilibrium model,"
LSE Research Online Documents on Economics
451, London School of Economics and Political Science, LSE Library.
- Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
- Biais, Bruno & Bossaerts, Peter, 1998. "Asset Prices and Trading Volume in a Beauty Contest," Review of Economic Studies, Wiley Blackwell, vol. 65(2), pages 307-40, April.
- Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-57, May.
- Mark S. Seasholes & Terrence Hendershott, 2007. "Market Maker Inventories and Stock Prices," American Economic Review, American Economic Association, vol. 97(2), pages 210-214, May.
When requesting a correction, please mention this item's handle: RePEc:sef:csefwp:276. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Lia Ambrosio)
If references are entirely missing, you can add them using this form.