Trading Volume and Asset Prices

Price and quantity are the two fundamental variables in any analysis of market interactions. Yet the study of financial markets has focused primarily on the behavior of asset prices¡ªpredictability, volatility, and their relation to economic fundamentals. Far less attention has been devoted to the understanding of quantities such as trading volume. Only recently, there has been a growing body of work to link both price and volume to economic fundamentals. In this paper, I attempt to review some of these work within a unified framework. I start by describing an intertemporal asset pricing model that explicitly models investors¡¯ trading motives, their optimal portfolio choices and the resulting equilibrium asset prices. I then examine the price-volume implications within the framework of the model. Finally, I discuss the results from the empirical analysis of volume and stock returns based on the data of the U.S. stock market. The theoretical analysis together with its empirical support clearly demonstrate that volume and prices are jointly linked to the economic fundamentals, e.g., the risks of the assets and the investors¡¯ attitude toward them. Moreover, the behavior of volume is closely related to the behavior of prices and from which we can learn a great deal about the prices as well as the economic fundamentals.