Discussion Paper Details

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Title: Expectations, Liquidity, and Short-term Trading

Author(s): Giovanni Cespa and Xavier Vives

Publication Date: March 2011

Keyword(s): Average expectations, Beauty Contest, Expected returns, High Frequency Trading, momentum and reversal, Multiple equilibria, Over-reliance on public information and price crash

Programme Area(s): Financial Economics

Abstract: In a market with short term agents and heterogeneous information, when liquidity trading displays persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors exploit a private learning channel to infer the demand of liquidity traders from the order flow to anticipate the evolution of the future aggregate demand for the stock. This yields multiple equilibria which can be ranked in terms of liquidity and informational effciency. Our results have implications for the impact of High Frequency Trading (HFT) on market quality and for the role of average expectations inasset pricing. We show that with persistence HFT can enhance informational efficiency and liquidity -- though creating an unstable equilibrium. In the equilibrium with high (low) informational effciency, prices are closer to (farther away from) fundamentals compared to consensus estimates.

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Bibliographic Reference

Cespa, G and Vives, X. 2011. 'Expectations, Liquidity, and Short-term Trading'. London, Centre for Economic Policy Research.