Asset Price Dynamics with Limited Attention

This paper studies the role that limited attention and inefficient risk sharing play in stock price deviations from the efficient prices at horizons from one day to one month. We expand the Duffie (2010) slow-moving capital model to analyze multiple groups of investors who have varying levels of attention. We test the model’s implications through an analysis of the joint dynamics of stock price movements and trading by the different types of investors. The model is consistent with contemporaneous, lead, and lag correlations among returns and trading at daily, weekly, biweekly, and monthly frequencies. We quantify limited attention’s economic effects on asset prices by estimating a reduced form version of our model on New York Stock Exchange data. A one standard deviation change in market maker inventories is associated with transitory price movements of 65 basis points at a daily frequency and 159 basis points at a monthly frequency. 8% of a stock’s daily idiosyncratic return variance and 25% of a its monthly idiosyncratic variance are due to transitory price changes (noise) and the trading variables explain 32% of this noise.