Market liquidity and excess volatility: Theory and experiment

Understanding the sources of excess volatility is a prominent question in finance. We theoretically examine the interaction between financial market development, specifically market liquidity, and excess volatility. Using a game theoretic model of investor behavior where agents learn about the fundamental value of assets over time, we highlight how market liquidity impacts traders' sensitivity to information about assets and how this impacts excess volatility in the market. We explore these predictions in laboratory asset markets where liquidity is exogenously varied and find that traders' sensitivity to news about asset values and excess volatility is higher in low liquidity markets. We also find that traders in low liquidity markets have an over-sensitivity, relative to theory, to the liquidations of others, suggesting that herding behavior is more prominent in less liquid markets. (C) 2022 Elsevier B.V. All rights reserved.