Disagreement and Liquidity

Disagreement is an increasingly popular explanation for trade of informationally sensitive securities. Yet, there is limited research on the relation between disagreement and liquidity, particularly regarding how disagreement affects private information's impact on trading and liquidity. This paper proposes a model in which trading is entirely generated by disagreement stemming from overconfident interpretation of private signals. Contrary to traditional intuition, the model predicts that private information increases trading and enhances liquidity. A more general version of the model incorporates both disagreement and liquidity trading. The general model relates traditional intuition about private information destroying liquidity and trade to disagreement trading. The relation between private information and liquidity is not monotonic. Private information at first decreases liquidity but then enhances it, potentially explaining why private information seems to destroy liquidity in money markets but not in markets that are more informationally sensitive to start with.