A Structural Model of Short-Term Reversals

67 Pages Posted: 17 Mar 2011 Last revised: 27 Sep 2017

Matti Suominen

Aalto University School of Business

Kalle Rinne

Luxembourg School of Finance

Date Written: December 16, 2011

Abstract

We present a structural model of the stock market where a subset of the investors is infrequently present at the market. In our model the stocks’ return reversal pattern is exponential and the amount of return reversal, the speed of return reversal and stock’s transitory volatility are all related to liquidity. In contrast to common perception, fast return reversal is typically a sign of inefficient, illiquid markets, thus not a sign of efficiency. Other results are that the stock’s return liquidity premium and the cost of immediacy to transitory investors are non-monotonic in several structural parameters of the model, such as the number of market makers.

Based on the entire available return history for NYSE and Amex traded stocks, we find that, on average, 24% of NYSE and Amex traded stocks’ excess returns revert within a week, that the pattern of return reversal is exponential, and that nearly 20% of daily volatility is transitory. Both the speed of return reversal and the amount of transitory volatility depend on the stock’s liquidity: For illiquid stocks, return reversals are faster and a greater amount of the volatility, 27%, is transitory. Our estimates of the total costs of immediacy suffered by investors, as a percentage of stock’s market capitalization, are non-monotonic in stock’s liquidity.

Keywords: Short-term reversals, liquidity, transitory volatility, illiquidity premium, costs of immediacy

JEL Classification: G10. G11, G12

Suggested Citation

Suominen, Matti and Rinne, Kalle, A Structural Model of Short-Term Reversals (December 16, 2011). AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1787270 or http://dx.doi.org/10.2139/ssrn.1787270

Matti Suominen

Aalto University School of Business ( email )

PO Box 1210
FI-00101 Helsinki
Finland
+358-50-5245678 (Phone)

Kalle Rinne (Contact Author)

Luxembourg School of Finance ( email )

4 Rue Albert Borschette
Luxembourg, L-1246
Luxembourg

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