Expectations, Liquidity, and Short-term Trading

Giovanni Cespa and Xavier Vives

No 3390, CESifo Working Paper Series from CESifo

Abstract: We consider a two-period market with persistent liquidity trading and risk averse privately informed investors who have a one period horizon. With persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors engage in “retrospective” learning to reassess the inference about fundamentals made at the early stage of the trading game. This introduces strategic complementarities in the use of information and can yield two stable equilibria which can be ranked in terms of liquidity, volatility, and informational efficiency. We establish the limits of the beauty contest analogy for financial markets and derive a rich set of implications to explain market anomalies, and empirical regularities.

Keywords: price speculation; multiple equilibria; average expectations; public information; momentum and reversal; Beauty Contest (search for similar items in EconPapers)
JEL-codes: G10 G12 G14 (search for similar items in EconPapers)
Date: 2011
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