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Strategic Trading and Learning about Liquidity

(by Sven Rady, with Harrison Hong)


Journal of Financial Markets 5(4), November 2002, pp. 419-450

Earlier versions of this work were circulated as:
CEPR Discussion Paper No. 2416
LSE Financial Markets Group Discussion Paper No. 356
Munich Department of Economics Discussion Paper No. 01-03

Many practitioners point out that the speculative profits of institutional traders are eroded by the difficulty in gauging the price impact of their trades. In this paper, we develop a model of strategic trading where speculators face such a dilemma because of incomplete information about time-varying market liquidity. Unlike the competitive market makers that they trade against, informed traders do not know whether the liquidity ("noise") trades are generated from a distribution with high or low variance. Instead, they have to learn about liquidity from past prices and trading volume. This learning implies that strategic trades and market statistics such as informational efficiency are path-dependent on past market outcomes. Our paper also has a number of normative implications for practitioners.

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