The Equity Volume Puzzle

Abstract

Critics of EMH have for years argued that the volumes of equity traded are too much. Prior research has, however, not quantified the volumes implied by rational trading. In this paper we present estimates of equity volumes produced by a rational exchange economy model in which agents trade due to their being risk-averse. Such risk-sharing is one of the rational explanations offered to explain trading. We find that the volumes due to such rational trading are an order of magnitude smaller than empirically observed volumes. The estimates of volumes and holding periods are based on simulations of the exchange economy of Constantinides (1986). In the past, both rational and behavioral models have focused on the equity premium as a major failing of rational models and have sought to explain the same. Prices are, however, not the only implications of rational models; volumes are an additional dimension along which these models may be evaluated. We also briefly discuss the problems with four other candidate rational explanations for trading: asymmetric information, life-cycle, liquidity shocks and predictability.