Liquidity Formation and Preopening Periods in Financial Markets

Jieying Hong and Sébastien Pouget

Economica, 2021, vol. 88, issue 351, 697-723

Abstract: This paper studies the role of preopening periods in liquidity formation and welfare in financial markets. Because no transaction occurs during these preopening periods, their economic significance could be questioned. We model a market where costly participation and asymmetric information prevent latent liquidity from being expressed. At equilibrium, risk‐averse insiders use preopening periods to better coordinate supply and demand of liquidity by communicating liquidity needs, thus improving welfare. Partial or full communication of private signals by the insider with the asset at preopening periods does not always enhance liquidity formation, but improves welfare through reducing adverse selection risk faced by the outsider, and increasing the likelihood of her entry. Our findings have implications for portfolio management and the design of financial markets.

Date: 2021
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