Working Paper: CEPR ID: DP8303
Authors: Giovanni Cespa; Xavier Vives
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.
Keywords: average expectations; beauty contest; expected returns; multiple equilibria; overreliance on public information
JEL Codes: G10; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher order expectations (HOEs) (D84) | overreliance on public information (D83) |
| overreliance on public information (D83) | high illiquidity (G33) |
| overreliance on public information (D83) | low volume of informational trading (G14) |
| Higher order expectations (HOEs) (D84) | low informational trading volume (G14) |
| subdued HOEs about fundamentals (R21) | less reliance on public information (D89) |
| less reliance on public information (D89) | higher liquidity states (H74) |
| less reliance on public information (D89) | increased volume of informational trading (G14) |
| expectation of future illiquidity (D84) | current trading behavior (G40) |
| expectation of future illiquidity (D84) | current liquidity (E41) |