“Risk-averse Liquidity Investors, Strategic Trading, and Return Dynamics” by Min Guo
Shanghai Jiaotong University
Albert S. Kyle
This paper develops an infinite horizon asset-pricing model on price impact with a risk-averse informed investor, who trades strategically, and competitive risk-averse liquidity investors. This model helps explain several financial anomalies, including price continuation/reversal, post-earnings announcement drift, and excess return volatility. Our theory is based on the time-varying premium demanded by risk-averse liquidity investors. We show the magnitudes of these anomalies depend crucially on a number of factors: cash flow uncertainty, the uncertainty and persistency of noise and private signal, and the ratio between the risk-aversion coefficients of liquidity investors and the informed investor. The informed investor behaves rationally as a trend-chaser in the short run and a contrarian in the long run, whereas the uninformed liquidity investor trades rationally as a contrarian in the short term and a trend-chaser in the long term. The model also offers a set of testable hypotheses regarding price dynamics, expected returns, price volatilities, and specifies a testable form for market depth, which distinguishes rigorously the price impacts due to asymmetric information and inventory effect.