Expectations, Liquidity, and Short-term Trading

We consider a two-period market with persistent liquidity trading and risk averse privately informed investors who have a one period horizon. With persistence, prices reflect average expectations about fundamentals and liquidity trading. Informed investors engage in “retrospective” learning to reassess the inference about fundamentals made at the early stage of the trading game. 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. We establish the limits of the beauty contest analogy for financial markets and derive a rich set of implications to explain market anomalies, and empirical regularities.price speculation, multiple equilibria, average expectations, public information, momentum and reversal, Beauty Contest

The Beauty Contest and Short-Term Trading

Short-termism need not breed informational price inefficiency even when gen- erating Beauty Contests. We demonstrate this claim in a two-period market with persistent liquidity trading and risk-averse, privately informed, short-term investors and find that prices reflect average expectations about fundamentals and liquidity trading. Informed investors engage in “retrospective” learning to reassess inferences (about fundamentals) made during the trading game’s early stages. This behavior introduces strategic complementarities in the use of information and can yield two stable equilibria that can be ranked in terms of liquidity, volatility, and informational efficiency. We derive implications that explain market anomalies as well as empirical regularities

Dynamic trading and asset prices: Keynes vs. Hayek

We investigate the dynamics of prices, information, and expectations in a competitive, noisy, dynamic asset pricing equilibrium model with long-term investors. We argue that the fact that prices can score worse or better than consensus opinion in predicting the fundamentals is a product of endogenous short-term speculation. For a given positive level of residual pay-off uncertainty, if liquidity trades display low persistence, rational investors act like market makers and accommodate the order flow and prices are farther away from fundamentals compared to consensus. This defines a "Keynesian" region; the complementary region is "Hayekian" in that rational investors chase the trend and prices are systematically closer to fundamentals than average expectations. The standard case of no residual uncertainty and liquidity trading following a random walk is on the frontier of the two regions and identifies the set of deep parameters for which rational investors abide by Keynes' dictum of concentrating on an asset "long-term prospects and those only". The analysis also explains momentum and reversal in stock returns and how accommodation and trend-chasing strategies differ from these phenomena

Rethinking macroeconomics: how G5 currency markets have responded to unconventional monetary policy

The G5 carry trade, where high interest rate currencies appreciate and low interest rate currencies depreciate, had been a persistent anomaly in financial markets since the collapse of Bretton Woods in 1971. Conventional economics said that the reverse should happen: low interest rates were supposed to stimulate the domestic economy, leading to growth and currency appreciation, rather than fund cross-border positions in search of higher yields. The Global Financial Crisis resulted in a major dislocation of currency markets, after which the G5 carry trade reversed. This paper is an empirical study of this reversal, and the implications for macroeconomic theory. Using overnight and one-month carry trades as a proxy for market reactions to monetary policy, the period leading up to the Global Financial Crisis and this reversal was increasingly subdued: the so-called ‘Great Moderation’. Financial crises show up as outliers in the data: temporary reversals of the carry trade during which periods central banks provide additional liquidity in the form of lower interest rates. These results suggest that, prior to 2008, conventional monetary policy – using high/low interest rates to dampen/boost growth and inflation – was being counteracted by capital flows in the opposite direction, in search of high yields. Only since 2008, with unconventional monetary policy – QE, negative interest rates and a reduction in banks’ proprietary trading – have G5 currencies responded as predicted by conventional economics: low/high interest rates G5 currencies have appreciated/depreciated. The results suggest that macroeconomic theories need to be reconsidered, to take account of cross-border capital flows in search of yield, and the effectiveness of unconventional monetary policy

Higher Order Expectations, Illiquidity, and Short-term Trading

We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reflect investors' Higher Order Expectations (HOEs) about the two factors that influence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis.Expected returns, multiple equilibria, average expectations, over-reliance on public information, Beauty Contest.

Great Expectations, Predictable Outcomes and the G20's Response to the Recent Global Financial Crisis: When Matters Relating to Liquidity Risks Become Equally as Important as Measures Addressing Pro cyclicality.

The meeting of the Governors and Heads of Supervision on the 12 September 2010, their decisions in relation to the new capital framework known as Basel III, as well as the endorsement of the agreements reached on the 26 July 2010, once again, reflect the typical situation where great expectations with rather unequivocal, and in a sense, disappointing results are delivered. The outcome of various consultations by the Basel Committee on Banking Supervision, consultations which culminated in the present Basel III framework, also reflect the focus on measures aimed at addressing problems attributed to Basel II, that is, measures aimed at mitigating pro cyclicality. This is rather astonishing given one critical lesson which has been drawn from the recent Financial Crisis: namely, that capital measures on their own, were and are insufficient in addressing and averting the Financial Crisis. Furthermore, banks which have been complying with capital adequacy requirements could still face severe liquidity problems. As well as an increase of the minimum common equity requirement from 2% to 4.5%, the recent agreement and decisions of the Governors and Heads of Supervision also include the stipulation that banks hold a capital conservation buffer of 2.5% - hence consolidating the stronger definition of capital (as agreed in the previous meeting held by the Governors and Heads of Supervision earlier in July 2010)

The zero-interest-rate and the role of the exchange rate for monetary policy in Japan

In this paper we study the role of the exchange rate in conducting monetary policy in an economy with near-zero nominal interest rates as experienced in Japan since the mid-1990s. Our analysis is based on an estimated model of Japan, the United States and the euro area with rational expectations and nominal rigidities. First, we provide a quantitative analysis of the impact of the zero bound on the effectiveness of interest rate policy in Japan in terms of stabilizing output and inflation. Then we evaluate three concrete proposals that focus on depreciation of the currency as a way to ameliorate the effect of the zero bound and evade a potential liquidity trap. Finally, we investigate the international consequences of these proposals

Might a Securities Transactions Tax Mitigate Excess Volatility?: Some Evidence From the Literature

International financial markets are said to be excessively volatile due to destabilizing speculation and excessive market volume. Transactions taxes might help. From studying the literature we conclude that there must be an optimal market liquidity, which minimizes excess volatility. There are two effects when imposing a transactions tax. Both reduce excess volatility in highly speculative markets when tax rates are small. The total tax effect then is unambiguous. However, in illiquid markets the tax might raise volatility.International Financial Markets, Securities Transactions Tax, Excess Volatility

Can TIPS help identify long-term inflation expectations?

Investors and policymakers have long hoped that Treasury Inflation Protected Securities (TIPS) would provide an accurate measure of long-term market inflation expectations. To make informed decisions and to ensure that inflation does not erode the purchasing power of their assets, investors need to assess the rate of inflation expected by other market participants. Having an accurate measure of market inflation expectations can also help policymakers assess their effectiveness in controlling long-term inflation, as well as their credibility among market participants.> Until recently, however, the only sources of information about long-term inflation expectations were surveys and the term structure of interest rates, neither of which were considered highly reliable. With the introduction of TIPS in 1997, it was hoped that a new measure of market inflation expectations—the difference in yields between conventional Treasuries and TIPS—would become available.> Shen and Corning examine the empirical evidence on the behavior of the yield difference and the liquidity of the TIPS market. They find that the yield difference has not provided a good measure of market inflation expectations because of the large and variable liquidity premium on TIPS. Still, the yield difference may become a better measure of market inflation expectations as liquidity conditions in the two kinds of Treasury markets move closer in the future.Inflation (Finance) ; Government securities