A Model of Competitive Stock Trading Volume Jiang Wang iMassachzcsetts Institute of Technology A model of competitive stock trading is developed in which investors are heterogeneous in their information and private investment opportunities and rationally trade for both informational and non-informational motives. I examine the link between the nature of heterogeneity among investors and the behavior of trading volume and its relation to price dynamics. It is found that volume is positively correlated with absolute changes in prices and dividends. I show that informational trading and non informational trading lead to different dynamic relations between trading volume and stock re- turns. I. Introduction Trading volume plays a minor role in conventional models of asset prices (e.g., Merton 1973;
Lucas 1978). Part of this is justified under the representative agent paradigm. When the asset market is complete and there exists a representative agent, the resulting allocation is optimal and asset prices are determined purely by the aggregate risk.' Trading in the market only reflects the allocation of the aggre- I thank Andrew Alford, Bruce Grundy, Chi-fu Huang, Paul Pfleiderer, and Deborah Lucas and seminar participants at Cornell University, Massachusetts Institute of Technology, Princeton University, University of Alberta, University of British Columbia, University of California at Berkeley, University of Chicago, and University of Pennsylvania for helpful comments. I also thank JosC Scheinkman (the editor) and an anonymous referee for valuable suggestions. The support from the Nanyang Technological University Career Development Assistant Professorship and the International Financial Services Research Center at MIT is gratefully acknowledged. ' Market completeness is meant in the sense of Harrison and Kreps (1979). For a discussion on the representative agent models, see, e.g., Constantinides (1982, 1989). [Jouml of Poltttcal Economy, 1994, vol. 102, no. I] 0 1994 by The Unitersity of Chicago. All rights reserved. 0022-380819410201-0004$01.50 128 JOURNAL OF POLITICAL ECONOMY gate risk and the diversification of individual risks among investors. It provides no additional information about prices given characterizations of the aggregate risk. The weak empirical performance of the representative agent models has led researchers to develop models with heterogeneous investors and an incomplete asset market (see, e.g., Mankiw 1986; Scheinkman and Weiss 1986; Lucas 199 1 ; Marcet and Singleton 1991; Campbell and Kyle 1993; Heaton and Lucas 1993; Wang 1993). With an incomplete asset market, both the aggregate and individual risks affect equilibrium prices, and the behavior of prices crucially depends on the nature of investor heterogeneity. In these models, quantity variables such as trading volume have im- portant roles to play. Investors trade among themselves because they are different. Thus the behavior of trading volume is closely linked to the underlying heterogeneity among investors. By examining the dynamic relation between volume and prices, one can study how the nature of investor heterogeneity determines the behavior of asset prices. In this paper, I develop an equilibrium model of stock trading in which investors are heterogeneous in their information and private investment opportunities and rationally trade for both informational and non-informational reasons. I use the model to study the behavior of stock trading volume and...
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