Frequent Trading and Price Impact in Thin Markets

Abstract

Extensive empirical research has shown that large institutional investors have significant price impact and they mitigate its adverse effects through their trading strategies. The competitive equilibrium asset-pricing models, which assume price-taking, are not suitable to model markets with large investors. We develop a dynamic model with multiple assets and many traders who take into account their impact on prices. The price impact, defined as a slope of the demand function faced by each investor, is derived from the market primitives: number of traders, return variability and risk preferences. The model predicts that the price impact is not constant over the trading period, but varies with time-to-maturity. The results match a number of empirical facts that cannot be reconciled with price-taking behavior: e.g., optimal execution of trade through breaking-up orders into blocks, asset price overshooting, contemporaneous and dynamic relation between return, price impact and trading volume. As in the presence of price impact cash and market values of portfolios do not coincide, we also study asset valuation.