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Higher Order Expectations, Illiquidity, and Short Term Trading

Xavier Vives and Giovanni Cespa

No 929, 2011 Meeting Papers from Society for Economic Dynamics

Abstract: We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reect investors' Higher Order Expectations (HOEs) about the two factors that influence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.

Date: 2011
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Working Paper: Higher order expectations, illiquidity, and short-term trading (2011) Downloads
Working Paper: Higher Order Expectations, Illiquidity, and Short-term Trading (2011) Downloads
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More papers in 2011 Meeting Papers from Society for Economic Dynamics Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA. Contact information at EDIRC.
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