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Incomplete Information and the Liquidity Premium Puzzle

Chen, Yingshan and Dai, Min and Goncalves-Pinto, Luis and Xu, Jing and Yan, Cheng (2020) 'Incomplete Information and the Liquidity Premium Puzzle.' Management Science. ISSN 0025-1909

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Abstract

We examine the problem of an investor who trades in a market with unobservable regime shifts. The investor learns from past prices and is subject to transaction costs. Our model generates significantly larger liquidity premia compared with a benchmark model with observable market shifts. The larger premia are driven primarily by suboptimal risk exposure, as turnover is lower under incomplete information. In contrast, the benchmark model produces (mechanically) high turnover and heavy trading costs. We provide empirical support for the amplification effect of incomplete information on the relation between trading costs and future stock returns. We also show empirically that such amplification is not driven by turnover. Overall, our results can help explain the large disconnect between theory and evidence regarding the magnitude of liquidity premia, which has been a longstanding puzzle in the literature.

Item Type: Article
Uncontrolled Keywords: regime shifts, incomplete information, transaction costs, liquidity premia
Divisions: Faculty of Social Sciences > Essex Business School
Faculty of Social Sciences > Essex Business School > Essex Finance Centre
Depositing User: Elements
Date Deposited: 25 Jan 2021 08:31
Last Modified: 25 Jan 2021 09:15
URI: http://repository.essex.ac.uk/id/eprint/29594

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