Institutionalization and Trading Inertia

This paper examines the market effects of large financial institutions in a two-period setting. We explore the intertemporal asset allocation of different investors and find that investors incline to trade more aggressively in the first trading period. However, this aggressiveness is weakened for large investors by their concern about price impact. Moreover, large investors exhibit trading inertia and their trading volumes display positive serial correlation. The existence of market-powered large investors increases return volatility and price reversals in the market. These trading patterns and price dynamics are intensified as market becomes more concentrated in large investors. We extend our model to another three settings: (1) multiple-large-investor case, where we suppose there are more than one large investors in the market and discover that as the number of large investors rises, the volume autocorrelation, price reversal, and return volatility decline simultaneously; (2) information asymmetry case, where large investors have information advantage over small investors; (3) correlated exogenous shocks case, where we assume the exogenous liquidity shocks in different trading periods are autocorrelated. Our main findings are robust in these three extensions and the results in this paper provide some testable hypotheses for further empirical studies and some implications for improving market efficiency.