Trading and Liquidity with Limited Cognition

49 Pages Posted: 15 Dec 2010

See all articles by Bruno Biais

Bruno Biais

Centre for Economic Policy Research (CEPR)

Johan Hombert

HEC Paris - Finance Department

Pierre-Olivier Weill

University of California, Los Angeles; National Bureau of Economic Research (NBER)

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Date Written: December 13, 2010

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, limit-orders, asset pricing and liquidity, algorithmic trading, limited cognition, sticky plans

JEL Classification: D83, G12

Suggested Citation

Biais, Bruno and Hombert, Johan and Weill, Pierre-Olivier, Trading and Liquidity with Limited Cognition (December 13, 2010). Available at SSRN: https://ssrn.com/abstract=1725025 or http://dx.doi.org/10.2139/ssrn.1725025

Bruno Biais

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Johan Hombert

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France

Pierre-Olivier Weill (Contact Author)

University of California, Los Angeles ( email )

Box 951477
Los Angeles, CA 90095-1477
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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