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I am thoroughly reading my first academic literature and I have found myself overwhelmed by terms that have been generalised in my studies.

The extract is from "The Beauty Contest and Short-Term Trading" by Giovanni Cespa and Xavier Vives, and states

'Consider a one-period stock market in which a single risky asset (of liquidation value $v$) and a riskless asset are traded by a continuum of risk-adverse, informed investors in the interval $[0,1]$ and also by liquidity traders.'

Who are liquidity traders? What is their purpose? What's an example of a liquidity trader and how would they contrast with the aforementioned informed trader?

In addition, the paper continues

'Liquidity traders submit a random market order $u$, where $u$ is distributed according to $N(0,\tau^{-1})$'

Now I'm curious on the connection between random orders and liquidity traders. In addition, what quantity does $u$ represent?

I apologise for my ignorance.

Regards,

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Liquidity traders have no discretion with regard to the timing of their trades. Their trades are triggered by exogenous (to the financial market) reasons and are not related to information.

Then we can not guess/forecast their trades and that's why we can consider the quantity (not the price) they ask/offer as random variables.

An academic definition :

Two motives for trade in financial markets are widely recognized as important: information and liquidity. Informed traders trade on the basis of private information that is not known to all other traders when trade takes place.

Liquidity traders, on the other hand, trade for reasons that are not related directly to the future payoffs of financial assets-their needs arise outside the financial market. Included in this category are large traders, such as some financial institutions, whose trades reflect the liquidity needs of their clients or who trade for portfolio-balancing reasons.

Admati, A. R., & Pfleiderer, P. (1988). A Theory of Intraday Patterns: Volume and Price Variability. The Review of Financial Studies, 1(1), 3–40. http://doi.org/10.1093/rfs/1.1.3

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  • $\begingroup$ A perfect answer. I wish I could give you bonus points for your academic reference. Thank you Malick. $\endgroup$ – Gustavo Louis G. Montańo Apr 22 '16 at 10:25

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