Financial Market Liquidity: Who is Acting Strategically?
43 Pages Posted: 6 Oct 2015 Last revised: 6 Jul 2016
Date Written: June 30, 2016
In a new environment where liquidity providers as well as liquidity consumers act strategically, understanding how liquidity flows and dries-up is key. In this paper, we propose a dynamic extension of the seminal model of Tauchen and Pitts (1983)’ Mixture of Distributions Hypothesis (MDH) that specifies the impact of information arrival on market characteristics in the context of liquidity frictions. In our model, the daily price change and volume processes are represented by a bivariate mixture of distributions, conditioned by two latent time-persistent variables It and Lt. Since the price change and volume equations are nonlinear functions of the first latent variable It, we use an Extended Kalman Filter (EKF) to filter the two latent variables and estimate the model parameters, simultaneously. This procedure enables us to: (i) capture the impact of long-lasting liquidity frictions on the daily price change and volatility dynamics; (ii) separate out the impact of both long and short-lasting liquidity frictions, on the serial correlation of the daily volume. Our results show that, 48% (44/92) of the stocks of the FTSE100 are actually facing liquidity problems. Amongst these stocks, 28% (26/92) of them are also facing a slow-down in the information propagation in prices due to long-term investors’ strategic behavior.
Keywords: Strategic liquidity trading, market efficiency, mixture of distribution hypothesis, information-based trading, extended Kalman Filter
JEL Classification: C51, C52, G12, G14
Suggested Citation: Suggested Citation