A Theory of Limited Liquidity and Large Investors Causing Spikes in Stock Market Volatility and Trading Volume

Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and H. Eugene Stanley

Journal of the European Economic Association, 2007, vol. 5, issue 2-3, 564-573

Abstract: We survey a theory of the economic underpinnings of the fat-tailed distributions of a number of financial variables, such as returns and trading volumes. Our theory posits that they have a common origin in the strategic trading behavior of very large financial institutions in a relatively illiquid market. We show how the fat-tailed distribution of fund sizes can indeed generate extreme returns and volumes, even in the absence of fundamental news. Moreover, we are able to replicate the individually different empirical values of the power law exponents for each distribution. Large investors moderate their trades to reduce their price impact; coupled with a concave price impact function, this leads to volumes being more fat-tailed than returns but less fat-tailed than fund sizes. The trades of large institutions offer a unified explanation for apparently disconnected empirical regularities that are otherwise a challenge for economic theory. (JEL: G12, G14, G23) (c) 2007 by the European Economic Association.

Date: 2007
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