DP2416 Strategic Trading And Learning About Liquidity

Author(s): Harrison G Hong, Sven Rady
Publication Date: April 2000
Keyword(s): Bayesian Learning, Liquidity Uncertainty, Private Information, Strategic Trading
JEL(s): D40, D83, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2416

We develop a multi-period model of strategic trading in an asset market where traders are uncertain about market liquidity. In our model, informed traders strategically trade against competitive market makers to exploit their short-lived private information. Unlike market makers, informed traders do not know whether the liquidity ('noise') trades are generated from a distribution with high or low variance. Instead, informed traders have to learn about liquidity from past prices. We find the following. (1) Prices that deviate markedly from the forecast of terminal asset value based on public news tend to lead to revisions of informed traders' beliefs in favour of the low liquidity state. (2) This revision in beliefs results in less aggressive trading on private information by informed traders. (3) In turn, informational efficiency and trading volume are dependent on the path of prices. (4) Moreover, learning about liquidity also has interesting effects on the unconditional properties of optimal strategic trading policies.