Price informativeness and predictability: How liquidity can help

William T. Lin, Shih Chuan Tsai, David S. Sun

Research output: Contribution to journalArticle

Abstract

Information asymmetry and liquidity concentration has been widely discussed in literatures. This study shows how liquidity influences not only forecasting performances of term structure estimation, but also information transmission and price adjustment across markets. Our analysis helps understanding how extreme market movements affect one another. This study examines, and provides a rationale for incorporating, liquidity in estimating term structure. Forecasting performance can be greatly enhanced when conditioning on trading liquidity. It reduces information asymmetry in the sense of Easley and O'Hara (2004) and Burlacu et al. (2007). We adopt a time series forecasting model following Diebold and Li (2006) to compare behaviour of forecasted price errors. Our findings indicate that forecasted price errors in markets with less depth would influence those with more. Information asymmetry induces volatile trading first and then price adjustment is transmitted to another market due to insufficient market depth. Cross-market price adjustment could be as much as 21 bps on average. Compared with previous studies, our results establish a valid reason to condition on liquidity when forecasting prices.

Original languageEnglish
Pages (from-to)2199-2217
Number of pages19
JournalApplied Economics
Volume43
Issue number17
DOIs
Publication statusPublished - 2011 Jul 1

ASJC Scopus subject areas

  • Economics and Econometrics

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