Information-Based Trading and the Bid-Ask Spread (original) (raw)
Related papers
Informed Trading, Limit Order Book and Implementation Shortfall: Equilibrium and Asymptotics
SSRN Electronic Journal, 2020
We propose a static equilibrium model for limit order book where N ≥ 1 profit-maximizing investors receive an information signal regarding the liquidation value of the asset and execute via a competitive dealer with random initial inventory. While the dealer's initial position plays a role similar to noise traders in Kyle [16], he trades against a competitive limit order book populated by liquidity suppliers as in Glosten [12]. We show that an equilibrium exists for bounded signal distributions, obtain closed form solutions for Bernoulli-type signals and propose a straightforward iterative algorithm to compute the equilibrium order book for the general case. We obtain the exact analytic asymptotics for the market impact of large trades and show that the functional form depends on the tail distribution of the private signal of the insiders. In particular, the impact follows a power law if the signal has fat tails while the law is logarithmic in case of lighter tails. Moreover, the tail distribution of the trade volume in equilibrium obeys a power law in our model. We find that the liquidity suppliers charge a minimum bid-ask spread that is independent of the amount of 'noise' trading but increasing in the degree of informational advantage of insiders in equilibrium. The model also predicts that the order book flattens as the amount of noise trading increases converging to a model with proportional transactions costs. In case of a monopolistic insider we show that the last slice traded against the limit order book is priced at the liquidation value of the asset. However, competition among the insiders leads to aggressive trading causing the aggregate profit to vanish in the limiting case N → ∞. The numerical results also show that the spread increases with the number of insiders keeping the other parameters fixed. Finally, an equilibrium may not exist if the liquidation value is unbounded. We conjecture that existence of equilibrium requires a sufficient amount of competition among insiders if the signal distribution exhibit fat tails.
Informed trading and the ‘leakage’ of information
Journal of Economic Theory, 2003
This paper, in a Shapley-Shubik market game framework, examines the effect of "leakage" of information: private information becoming available to uninformed traders at a later date. We show that (a) If information acquisition by the informed traders is costless, this leads to faster revelation of information; (b) If information acquisition is costly, there may be no acquisition of information; (c) Information leakage leads to a fall in value of information and hence, increases the incentive for informed traders to sell the information.
Information dissemination by insiders in equilibrium
Journal of Financial Markets, 2003
This paper generates an equilibrium explanation for partial disclosure of information by an insider to privileged associates. In our model, prices are set by competitive market makers in anticipation of trading volume, but not affected by the actual number of trades. Liquidity demand is not perfectly inelastic, but rather liquidity traders are sensitive to trading costs through a reservation price. Because profits from liquidity traders are bounded, the feasibility of an equilibrium depends on the balance between the number of associates, the precision of information and the number of liquidity traders. Partially, rather than fully, disclosing information alters this balance by limiting the informational advantage of individual associates. If the number of associates is exogenous, partial disclosure prevents market failure. If the insider chooses the number of associates, partial disclosure allows him to serve more associates but still increase total associate profits.
Information and Liquidity Trading at Optimal Frequencies
SSRN Electronic Journal, 2010
This paper studies a continuous-time stochastic game of trading activity in financial markets under asymmetric information. The model has the following features. First, informed and liquidity traders optimally control the timing of their order submissions. Second, they continuously choose whether to take or provide liquidity, issuing market or limit orders. Third, uninformed traders learn from the order flow optimally exploiting the information in the limit-order book. I construct an equilibrium in this setting and characterize (i) price formation and (ii) how optimal submission intensities and liquidity supply-demand behavior depend on private information and market conditions. I show that all traders types demand and supply liquidity simultaneously, following a distinctive time-varying pattern previously found in experiments. After an information event, inter-arrival times are positively autocorrelated, the price impact of all order types increases and the limit-order book shows depth unbalances. The model nests the cases in which liquidity provision is decentralized (limit-order markets) and centralized (dealer markets). I find that the speed of information transmission into prices is lowered in the decentralized version. Since submission intensities are strategic, the time spacing of the data can be used to learn about traders' optimal policies. I use a unique orderlevel dataset from the NYSE to test structural restrictions on optimal liquidity provision and find support for the model's outcomes. The findings shed light on empirical and experimental results in the literature and have implications for inference methods with high frequency data.
Prices, Liquidity, and the Information Content of Trades
Review of Financial Studies, 2000
We investigate the effect of asymmetric information on prices and liquidity by analyzing trades, quotes, spreads and depths. Information content should increase with trade size and the degree of information asymmetry of the trading period. Results show that price and liquidity effects are significantly associated with information content as measured by both trade size and the timing of the trade relative to information events. Results are stronger for purchases than sales. Quoted prices are better measures of information effects than transaction prices, because they control for bid-ask bounce. Finally, trades that are known a priori not to contain information have no impact on prices and liquidity, even when they are very large in size.
Hidden and Displayed Liquidity in Securities Markets with Informed Liquidity Providers
Social Science Research Network, 2011
We examine the impact on the quality of a securities market of hiding versus displaying orders that provide liquidity. Display expropriates informational rents from informed agents who trade as liquidity providers. The informed then exit liquidity provision in favor of demanding liquidity where they trade less aggressively. Trading costs to uninformed liquidity demanders are higher, bid-ask spreads are wider and midquotes are less informationally efficient when orders that provide liquidity are displayed. Our analysis suggests that market innovations, which might seem to favor the informed over the uninformed, can enhance market quality by intensifying competition among the informed. 9 Other models that relax the assumption of perfect competition are Glosten (1989), Biais, Martimort and Rochet (2000) and Bondarenko (2001). However, they retain the assumption that dealers are uninformed and, as in Dennert, a single informed trader demands liquidity. 10 We do not constrain strategies to be linear. We show that linear strategies are optimal when agents conjecture that others follow linear strategies.
BID, ASK AND' TRANSACTION PRICES IN A SPECIALIST MARKET WITH HETEROGENEOUSLY INFORMED TRADERS
The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.
The Distribution of Information and the Price Efficiency of Markets
Journal of Economic Dynamics and Control, 2019
Apparently contradictory evidence has accumulated regarding the extent to which financial markets are informationally efficient. Shedding new light on this old debate, we show that differences in the distribution of private information may explain why informational efficiency can vary greatly across markets. We find that markets are informationally efficient when complete information is concentrated in the hands of competing insiders whereas they are less efficient when private information is dispersed across traders. A learning model helps to illustrate why inferring others' private information from prices takes more time when information is more dispersed. We discuss the implications of our findings for understanding the potential consequences of lowering the cost of information on the informational efficiency of markets.
Proceedings of the Royal Society A: Mathematical, Physical and Engineering Sciences, 2008
An asymmetric information model is introduced for the situation in which there is a small agent who is more susceptible to the flow of information in the market than the general market participant, and who tries to implement strategies based on the additional information. In this model market participants have access to a stream of noisy information concerning the future return of an asset, whereas the informed trader has access to a further information source which is obscured by an additional noise that may be correlated with the market noise. The informed trader uses the extraneous information source to seek statistical arbitrage opportunities, while at the same time accommodating the additional risk. The amount of information available to the general market participant concerning the asset return is measured by the mutual information of the asset price and the associated cash flow. The worth of the additional information source is then measured in terms of the difference of mutu...
Learning and Information Dissemination in Limit Order Markets
SSRN Electronic Journal, 2013
What can traders learn and how does learning affect the market? When information is asymmetric, short-lived, and uninformed traders learn, we present an artificial limit order market model to examine the effect of learning, information value, and order aggressiveness on information dissemination efficiency, bid-ask spread, order submission, and order profit of traders. We find that learning helps the uninformed traders to acquire private information more effectively and hence improves market information dissemination. Also the informed traders in general consume liquidity while the uninformed traders mainly supply liquidity. More interestingly, due to the learning and short-lived information, the bid-ask spread and its volatility are positively related to the probability of informed trading. The results help us to understand the behavior of uninformed traders and provide substantial insight and intuition into the trading process.