6 - Trading Volume

Summary

INTRODUCTION

One of the most fundamental notions of economics is the determination of prices through the interaction of supply and demand. The remarkable amount of information contained in equilibrium prices has been the subject of countless studies, both theoretical and empirical, and with respect to financial securities, several distinct literatures devoted solely to prices have developed. Indeed, one of the most well-developed and most highly cited strands of modern economics is the asset-pricing literature.

However, the intersection of supply and demand determines not only equilibrium prices but also equilibrium quantities, yet quantities have received far less attention, especially in the asset-pricing literature (is there a parallel asset-quantities literature?). One explanation for this asymmetry is the fact that, for most individual investors, financial markets have traditionally been considered close to perfectly competitive, so that the size of a typical investment has little impact on prices. For such scale-free investment opportunities, quantities are largely irrelevant and returns become the basic objects of study, not prices. But for large investors such as institutional investors, the securities markets are not perfectly competitive, at least not in the short run. Moreover, when investors possess private information – about price movements, their own trading intentions, and other market factors – perfect competition is even less likely to hold.

For example, if a large pension fund were to liquidate a substantial position in one security, that security's price would drop precipitously if the liquidation were attempted through a single sell-order, yielding a significant loss in the value of the security to be sold.