We consider a two-period market with persistent liquidity trading and risk averse privately informed investors who have a one period horizon. We study the drivers of asset prices in a two-period market where short-term, informed, competitive, risk-averse agents trade on account of private information and to accommodate liquidity supply, facing a persistent demand from liquidity traders. Suppose a risk-averse, short term trader has a private signal on the firm’s fundamentals.
The crux of our argument revolves around a particular type of inference effect from the information reflected by prices that arises when liquidity traders’ positions are correlated across trading dates.

With persistence, prices reflect average expectations about fundamentals and liquidity trading. Indeed, short term trading is at the base of Keynes’ dismal view of financial markets. We find that when liquidity trading is persistent there is strategic complementarity in the use of private information and provide sufficient conditions for it to be strong enough to generate multiple and stable equilibria which can be ranked in terms of price informativeness, liquidity, and volatility; this allows us to establish the limits of the beauty contest analogy for financial markets, and deliver sharp predictions on asset pricing which are consistent with the received empirical evidence (including noted anomalies). This introduces strategic complementarities in the use of information and can yield two stable equilibria which can be ranked in terms of liquidity, volatility, and informational efficiency.

In this paper we show that this two-sided loop can be responsible for the existence of multiple, stable equilibria that can be ranked in terms of informational efficiency, liquidity, and volatility.

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