Trading under uncertainty about other market participants

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I present an asymmetric information model of financial markets in which there
is uncertainty and learning not only about fundamentals but also about the proportion
of informed-to-noise traders in the market. Extreme news leads to an increase
in both types of uncertainty, while it decreases price informativeness. Uncertainty
about the market composition constitutes a type of liquidity risk and is associated
with high expected returns. The resulting price-volume relationship is U-shaped and
positively sloped. In a dynamic extension of the model I show that this mechanism
generates momentum as well as history-dependent volatility and price informativeness.
Original languageEnglish
JournalFinancial Review
Issue number2
Publication statusAccepted/In press - 6 Dec 2022


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