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The Trader's Dilemma: Trading Strategies and Endogenous Pricing in an Illiquid Market (No. E2005005)


Dan Liang* Frank Milne#
November 13, 2005

Abstract: We investigate a large trader's trading strategies in a decentralized market, in which all traders are subject to type switching. This trader has pressure to liquidate her position by the end of the horizon so as to avoid extra holding costs. She faces a trade-off: if she trades quickly, she moves the price too much; if she trades slowly, she may not be able to find counterparties in the market in later periods. We derive subgame perfect equilibria under three different spot market structures. These structures are chosen to show various degrees of competitive bargaining. We show that, in each equilibrium, the large trader chooses the optimal trading strategy to take into account both the price impact effect and liquidity uncertainty. Thus, asset prices are generated endogenously through a dynamic bargaining and trading process and reflect the impact of the large trader's trades. Small traders, who possess little market power, cannot be ignored because their reactions to the large trader's trading strategy jointly determines market liquidity. We show that limiting case of competitive pricing occurs when there are enough small traders, or there are many trading periods. Illiquidity is a result of the thin market for buyers, and their limited capacity to buy the asset sold by the large trader.

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*School of Business, Queen's University
#Department of Economics, Queen's University