Risk Aversion, Liquidity, and Endogenous Short Horizons
University of California, Los Angeles (UCLA) - Finance Area; Institute of Global Finance, UNSW Business School; Financial Research Network (FIRN)
Craig W. Holden
Indiana University - Kelley School of Business - Department of Finance
We analyze trading behavior and information acquisition in a competitive rational expectations model in which different information signals get reflected in value at different points in time (in the short-term and in the long-term). If investors are sufficiently risk averse, we obtain a unique equilibrium in which the entire mass of investors endogenously focuses on the short-term and thereby neglects long-run fundamentals. We also show that ``too much'' market liquidity (in the form of a large variance of informationless trading) causes a greater proportion of investors to focus on the short-term signal, which decreases the informativeness of prices about long-run determinants of value. Further, we show that long-term informed agents optimally postpone heavy trading until after the disclosure of public signals which partly resolve the uncertainty surrounding true value. This is consistent with empirical evidence of increases in trading volume immediately following quarterly earnings announcements. Finally, we explore an alternative framework in which informed agents may voluntarily and credibly disclose their information following an initial round of trade. We explore parameter spaces under which such disclosure is optimal.
JEL Classification: G12, G14
Date posted: June 13, 1994