Expectations and Market Microstructure when Liquidity is Lost,” mimeo

In this paper, we focus on the halt of price discovery function in the financial markets and the evaporation of market liquidity. We explore the mechanism of these phenomena by using simulation techniques shown in Muranaga and Shimizu (1999). In order to generate evaporation of market liquidity, we exogenously reduce traders ’ expected values of asset. In one simulation, it is assumed that market participants do not amend their expectations on future price levels in response to large movements in market prices, but instead become more uncertain about whether the expectations would be realised. The simulation result shows that the loss of market liquidity can play a role of a built-in stabiliser in the market, and can prevent a precipitous drop in prices. As uncertainty increases, market participants become less willing to trade, the number of orders declined, and, consequently, market liquidity evaporates. When market liquidity is low, price discovery is not conducted as often, so an endogenous (secondary) crash in prices is less likely to develop. In another simulation, it is assumed that market participants amend their expectations on future prices in response to large price movements and uncertainty remains unchanged. In this case, the simulation result suggests that secondary crashes might develop. This is because order flows, which would not be interrupted, coul