Strategic Trading and Learning About Liquidity

41 Pages Posted: 27 Mar 2000

See all articles by Sven Rady

Sven Rady

University of Bonn

Harrison G. Hong

Columbia University, Graduate School of Arts and Sciences, Department of Economics; National Bureau of Economic Research (NBER)

Date Written: August 2000

Abstract

Many practitioners point out that the speculative profits of institutional traders are eroded by the difficulty in gauging the price impact of their trades. In this paper, we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know whether the liquidity ("noise") trades are generated from a distribution with high or low variance. Instead, they have to learn about liquidity from past prices and trading volume. Extreme price deviations from forecasts of fundamentals based on public news or low trading volume tend to lead to revisions of beliefs in favor of the low liquidity state. This revision in beliefs implies that strategic trades and market statistics such as informational efficiency are path-dependent on past market outcomes. Our paper has a number of normative implications for practitioners concerned with gauging the potential price impact of their trades.

JEL Classification: D40, D83, G12, G14

Suggested Citation

Rady, Sven and Hong, Harrison G., Strategic Trading and Learning About Liquidity (August 2000). Available at SSRN: https://ssrn.com/abstract=215342 or http://dx.doi.org/10.2139/ssrn.215342

Sven Rady (Contact Author)

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Harrison G. Hong

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

420 W. 118th Street
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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