Equilibrium Pricing and Trading Volume under Preference Uncertainty

B. Biais, J. Hombert, P.-O. Weill
2014 The Review of Economic Studies  
Information collection and processing in financial institutions is challenging. This can delay the observation by traders of the exact capital charges and constraints of their institution. During this delay, traders face preference uncertainty. In this context, we study optimal trading strategies and equilibrium prices in a continuous centralized market. We focus on liquidity shocks, during which preference uncertainty is likely to matter most. Preference uncertainty generates allocative
more » ... iency, but need not reduce prices. Progressively learning about preferences generate round-trip trades, which increase volume relative to the frictionless market. In a cross section of liquidity shocks, the initial price drop is positively correlated with total trading volume. Across traders, the number of round-trips is negatively correlated with trading profits and average inventory. Gregory Mankiw and Ricardo Reis. Sticky information versus sticky prices: a proposal to replace the new keynesian phillips curve.
doi:10.1093/restud/rdu008 fatcat:eiwzpjxuqrdfhc2vmjmvxkkmam