Price Informativeness and Predictability: How Liquidity Can Help

33 Pages Posted: 23 Jan 2010 Last revised: 1 Jun 2012

See all articles by William T. LIn

William T. LIn

Tamkang University - Banking & Finance

Shih-Chuan Tsai

National Taiwan Normal University

David S. Sun

Kainan University

Date Written: October 18, 2009

Abstract

Information asymmetry and liquidity concentration has been widely discussed in literatures. This study shows how liquidity influences not only forecasting performances of term structure estimation, but also information transmission and price adjustment across markets. Our analysis helps understanding how extreme market movements affect one another. This study examines, and provides a rationale for incorporating, liquidity in estimating term structure. Forecasting performance can be greatly enhanced when conditioning on trading liquidity. It reduces information asymmetry in the sense of Easley and O’Hara (2004) and Burlacu, Fontaine and Jimenez-Garces (2007). We adopt a time series forecasting model following Diebold and Li (2006) to compare behavior of forecasted price errors. Our findings indicate that forecasted price errors in markets with less depth would influence those with more. Information asymmetry induces volatile trading first and then price adjustment is transmitted to another market due to insufficient market depth. Cross-market price adjustment could be as much as 21 bps on average. Compared with previous studies, our results establish a valid reason to condition on liquidity when forecasting prices.

Keywords: Liquidity; Trading Concentration, Information Asymmetry, Information Transmission, Yield Curve Fitting

JEL Classification: D82, E43, E47, G12

Suggested Citation

LIn, William T. and Tsai, Shih-Chuan and Sun, David S., Price Informativeness and Predictability: How Liquidity Can Help (October 18, 2009). Applied Economics, Vol. 43(17), 2199-2217. , Available at SSRN: https://ssrn.com/abstract=1540922

William T. LIn

Tamkang University - Banking & Finance ( email )

Department of Banking and Finance
Taiwan, 25137
Taiwan

Shih-Chuan Tsai

National Taiwan Normal University ( email )

No. 162, Section 1
Heping East Road
Taipei City, Da’an District 106
Taiwan

David S. Sun (Contact Author)

Kainan University ( email )

No. 1, Kāinán Rd
Taoyuan, Taiwan
Taiwan

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