Effects of market liquidity on price dynamics in a heterogeneous belief model

ABSTRACT

To understand the effect of liquidity on asset pricing, this study constructs a boundedly rational asset pricing model, introducing market liquidity and heterogeneous beliefs. Based on our model, we conduct empirical tests using the S&P 500 index from 1991 to 2021 and the CSI 500 index from 2007 to 2021. We find that market liquidity significantly influences investors’ expectations and belief switching. When market liquidity is scarce, fundamentalists in both markets expect the price to converge more quickly to its fundamental value, whereas chartists perceive that the price deviates from its fundamental value less rapidly. Lack of liquidity mitigates the investors’ original switching strategy, resulting in positive feedback as a net effect. Moreover, the S&P 500 index is efficient, whereas the CSI 500 index is slightly undervalued in the long run. Both markets exhibit large fluctuations and inefficiency during short periods such as the 2008 financial crisis and COVID-19 pandemic. As such, safeguards should be implemented against sudden shocks and the resulting price deviation and market inefficiency. © 2022 Informa UK Limited, trading as Taylor & Francis Group.