Demand Discovery and Asset Pricing

by Michael Gallmeyer of Texas A&M,
Burton Hollifield of Carnegie Mellon University, and
Duane Seppi of Carnegie Mellon University

August 2005

Abstract: Dynamic trading of long-dated securities exposes investors to resale price risk due to uncertainty about the future asset demands of their trading counter-parties. This paper specifically models trading and asset pricing when investors are asymmetrically informed about each other's preferences. Through a process we call demand discovery, trading reveals private information about counter-parties' preferences and, hence, about the preference-component in future prices. Demand discovery leads to endogenous joint dynamics in prices, trading volume, price volatility, and expected returns. As a result, trading volume and market liquidity are forward-looking proxies for preference risk in future prices. Demand discovery provides an alternative explanation to transaction costs for the empirical relationship between market liquidity and future returns.

Keywords: Liquidity risk, liquidity discovery, asset pricing.

Previously titled: Liquidity Discovery and Asset Pricing

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