Catching Falling Knives: Speculating on Liquidity Shocks

Abstract

Many market participants invest resources to acquire information about liquidity rather than fundamentals. I show that agents using such information can reduce the magnitude of short-lived pricing errors by trading against liquidity shocks. However, the short-run stabilizing effect of this behavior also makes it more difficult to identify liquidity shocks, a signal-jamming effect that slows down price discovery in the long-run. As more agents invest in non-fundamental information, market prices become more resilient to liquidity shocks, but also recover more slowly from temporary price deviations.

Keywords: supply information, non-fundamental uncertainty, market crashes, arbitrage

JEL Classification: D82, G0, G12, G14