Discussion of “Sidelined Investors, Trading-Generated News, and Security Returns”

Abstract

The article of Cao, Coval, and Hirshleifer (hereafter CCH) presents a stylized model of security trading able to explain some of the features of stock returns, such as (i) positive (negative) skewness after rundowns (run-ups); (ii) volatility clustering; and (iii) large changes in prices with no apparent information arrival. In this discussion I first outline the basic mechanism of the model (Section 1) and then discuss its assumptions and conclusions (Sections 2 and 3), also in light of competing theories. Final remarks are contained in Section 4. 1. The Basic Mechanism The main idea underlying CCH’s model can be summarized as follows. There are informed, uninformed, and noise traders, along with an uninformed competitive market maker (MM). Investors have heterogeneous transaction costs (TCs). Schematically the following chain of events occurs upon receiving a signal: (1) signal arrives ⇒ traders with low TCs place an order (buy or sell); (2) ⇒ the price moves (say up if buy order) and yields two effects: (a) it reveals information; (b) it makes the asset more expensive.