A structural model of short term reversals

In this paper, we study short term return reversals in the stock market. In our model, each period new investors arrive to the stock market with stochastic endowments, trade and then exit the market. The market makers retain a continuous presence in the stock market and carry over in time investors’ order imbalances. The price impact from investors’ order imbalances makes prices deviate from fundamentals and due to market makers’ inventory considerations, reversals take place only gradually. As the endowments of each generation of investors are stochastic, the market makers’ inventories are also stochastic. Time to time the market makers’ inventories accumulate to very high levels, implying that the short term expected returns to reversal trades become very high. Simulations show that a stock’s expected weekly return depends on its returns during several past days, but so that the effect of more distant days’ returns on future returns is smaller. The price impact from trading and the speed of mean reversion depend on the amount of investors and market makers in a nonlinear way.