Expectations, Liquidity, and Short-term Trading

Xavier Vives and Giovanni Cespa

No 8303, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: In a market with short term agents and heterogeneous information, when liquidity trading displays persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors exploit a private learning channel to infer the demand of liquidity traders from the order flow to anticipate the evolution of the future aggregate demand for the stock. This yields multiple equilibria which can be ranked in terms of liquidity and informational effciency. Our results have implications for the impact of High Frequency Trading (HFT) on market quality and for the role of average expectations inasset pricing. We show that with persistence HFT can enhance informational efficiency and liquidity -- though creating an unstable equilibrium. In the equilibrium with high (low) informational effciency, prices are closer to (farther away from) fundamentals compared to consensus estimates.

Keywords: Average expectations; Beauty contest; Expected returns; Multiple equilibria; Over-reliance on public information; High frequency trading; Momentum and reversal; Price crash (search for similar items in EconPapers)
JEL-codes: G10 G12 G14 (search for similar items in EconPapers)
Date: 2011-03
New Economics Papers: this item is included in nep-cba, nep-cta, nep-mst and nep-upt
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Working Paper: Expectations, Liquidity, and Short-term Trading (2011)
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