Working Paper: NBER ID: w16628
Authors: Bruno Biais; Johan Hombert; Pierre-Olivier Weill
Abstract: We study the reaction of financial 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 market price recovery. They also imply that traders who find that 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 place orders only when they have completed their information processing task.
Keywords: Liquidity Shock; Cognition Limits; Trading Volume; Market Recovery
JEL Codes: D83; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited cognition (D80) | delayed price recovery (G19) |
| liquidity shock (E44) | low valuations (G19) |
| low valuations (G19) | limited cognition (D80) |
| limited cognition (D80) | trading behavior (G41) |
| trading behavior (G41) | trading volume (G15) |
| algorithmic trading (C69) | trading volume (G15) |
| limited cognition (D80) | efficiency (D61) |