Higher Order Expectations, Illiquidity, and Short-Term Trading

Abstract

When trading frequencies between liquidity traders and short term, heterogeneously informed investors differ, asset prices reflect Higher Order Expectations (HOEs) about both fundamentals and liquidity trading, and multiple, self-fulfilling equilibria arise. Differential information and heterogeneous trading frequencies make illiquidity dependent on a coordination problem across generations of investors and generate liquidity risk. If asset prices are driven by HOEs about fundamentals, they heavily rely on public information and the market displays high illiquidity; if HOEs about fundamentals are subdued, prices rely less on public information and the market displays low illiquidity. Along the equilibrium with low illiquidity, the volume of informational trading is high, and momentum arises at short horizons. Conversely, along the equilibrium with high illiquidity the volume of informational trading is low and short term returns tend to revert. At long horizons reversal occurs.

Keywords: Expected returns, multiple equilibria, liquidity risk, average expectations, reliance on public information, momentum and reversal, Beauty Contest.

JEL Classification: G10, G12, G14