Incomplete Information and the Liquidity Premium Puzzle
Management Science, forthcoming
63 Pages Posted: 14 Dec 2018 Last revised: 27 May 2020
Date Written: February 10, 2020
We examine the problem of an investor who trades in a market with unobservable regime shifts. The investor learns from past prices and is subject to transaction costs. Our model generates significantly larger liquidity premia compared to a benchmark model with observable market shifts. The larger premia are driven primarily by suboptimal risk exposure, as turnover is lower under incomplete information. In contrast, the benchmark model produces (mechanically) high turnover and heavy trading costs. We provide empirical support for the amplification effect of incomplete information on the relation between trading costs and future stock returns. We also show empirically that such amplification is not driven by turnover. Overall, our results can help explain the large disconnect between theory and evidence regarding the magnitude of liquidity premia, which has been a longstanding puzzle in the literature.
Keywords: Regime Shifts, Incomplete Information, Transaction Costs, Liquidity Premia
JEL Classification: C61, D11, D91, G11
Suggested Citation: Suggested Citation