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Trading and liquidity with limited cognition

Pierre-Olivier Weill, Johan Hombert and Bruno Biais
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Johan Hombert: HEC Paris

No 118, 2012 Meeting Papers from Society for Economic Dynamics

Abstract: We study the reaction of nancial markets to aggregate liquidity shocks when traders face cognition limits. While each financial institution recovers from the shock at a random time, the trader representing the institution observes this recovery with a delay, reflecting the time it takes to collect and process information about positions, counterparties and risk exposure. Cognition limits lengthen the recovery process. They also imply that traders who find their institution has not yet recovered from the shock place market sell orders, and then progressively buy back at relatively low prices, while simultaneously placing limit orders to sell later when the price will have recovered. This generates round trip trades, which raise trading volume. We compare the case where algorithms enable traders to implement this strategy to that where traders can only place orders when they have completed their information processing task.

Keywords: Liquidity shock; limit-orders; asset pricing (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-mst
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Related works:
Working Paper: Trading and liquidity with limited cognition (2012)
Working Paper: Trading and Liquidity with Limited Cognition (2011) Downloads
Working Paper: Trading and Liquidity with Limited Cognition (2010) Downloads
Working Paper: Trading and Liquidity with Limited Cognition (2010) Downloads
Working Paper: Trading and Liquidity with Limited Cognition (2010) Downloads
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