Disagreement, Habit and the Dynamic Relation Between Volume and Prices

Dynamic asset pricing models typically do not generate trading volume whereas empirically trading volume is strongly related to asset prices; volume is usually high when returns are high and during periods of high return volatility. Stock prices on the other hand are known to be quite volatile and require a high equity premium while the risk-free rate of return is low and quite stable. We attempt to reconcile all these price and volume characteristics in a new model of disagreement where agents have external habit formation preferences that generate time-variation in risk-aversion. The model is flexible enough to be able to generate in a number of ways the dynamic relation between prices and volume whereas it also provides a configuration by which prices are also fitted well. The paper additionally shows that the information structure and the asset structure have important implications for the correlation between stock returns and volume