Market Belief, Trading Volume, Price Volatility, and Liquidity

This paper studies the effects of investors' heterogeneous beliefs on the trading volume, price volatility, and liquidity of assets. Following Kurz and Motolese (2008), we propose a theoretical model to show that the equilibrium asset price is linearly and positively correlated with market belief (investors' average belief) about its future payoffs. Further, it is also shown in this paper that when market belief becomes more volatile, trading volume and liquidity decline while price volatility increases. Using the analyst forecast data on quarterly earnings per share provided by the Institutional Brokers' Estimate System, we obtain, for the sample consisting of 114 S&P500 Index stocks, empirical results which support the theoretically predicted relations between the volatility of market belief about asset future payoffs and the trading volume, price volatility, and liquidity of underlying assets, and these empirical results are robust to various methods of estimating market belief and its volatility and to alternative illiquidity measures