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Dampening effect and market efficiency

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  • Guo, Mng

Abstract

The way informed traders use their privileged information affects the properties of asset prices. This paper analyzes the differences in market efficiency between the two most widely adopted informed trading paradigms (Grossman-Stiglitz-style and Kyle-style) in a unified three-period framework. The aggregate risk—the product of fundamental risk, liquidity trading risk, and traders’ risk aversion coefficient—uniquely determines three measures of market efficiencies, including price informativeness, return autocorrelations, and the unconditional expected utilities of uninformed market makers. In the Kyle-style model, a self-reinforcing dampening effect arises from informed traders’ trading on fundamental information and non-fundamental information about their prior positions, leading to less efficient markets, contrarian trading by informed traders, and a return reversal between the two trading periods. Our study proposes to estimate price informativeness using information from short-term return reversals.

Suggested Citation

  • Guo, Mng, 2023. "Dampening effect and market efficiency," Journal of Economic Dynamics and Control, Elsevier, vol. 148(C).
    • Handle: RePEc:eee:dyncon:v:148:y:2023:i:c:s0165188923000106
    DOI: 10.1016/j.jedc.2023.104604
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    More about this item

    Keywords

    Grossman-Stiglitz-style and kyle-style models; Dampening effect; Price informativeness and short-term return reversals; Contrarian trading; Aggregate risk;
    All these keywords.

    JEL classification:

    • D4 - Microeconomics - - Market Structure, Pricing, and Design
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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