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Noise and Competition in Strategic Oligopoly

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  • Ramdan Dridi
  • Laurent Germain
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    Abstract

    Focusing on homogeneous beliefs, we can distinguish two commonly shared ideas that, i) the competition between informed traders destroys their trading profits, ii) trading with a noisy signal brings about a loss in the expected profits. So far, it has been proved in the latter framework, that when N strategic and perfectly informed traders compete in the financial market, i) the informativeness of prices increases with the degree of competition and, ii) the aggregate and individual profits go to 0 when N is large. In this paper, we propose a general study where N strategic informaed agents have heterogeneous beliefs, i.e. are endowed with noisy information and compete à la Nash. We prove the existence and uniqueness of a linear equilibrium generalizing Kyle (1985) results to the case of N informed traders when the insiders have heterogeneous beliefs. In this general framework, we derive the following striking results: for certain regions of noise and numbers of competitors in excess of four, i) each individual expected profit is greater than the one obtained in the perfectly informed (and homogeneous beliefs) case; ii) the aggregate profit has a finite (strictly) positive limit when N is large. iii) Even when an infinite number of insiders compete in the market, the price is no longer efficient and does not fully reveal the final liquidation value of the risky asset. iv) In the particular case where each informed agent is endowed with a signal the precision of which is the same, a) we show that there exists an optimal level of noise for which each individual expected profit is maximized; b) we show that there exists an optimal size of the market for which the aggregate expectged profit is maximized; c) the liquidity is an increasing function of the number of informed traders but has a finite limit for large N; d) the informativeness of prices is a decreasing function of the number of informed traders.

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    Bibliographic Info

    Paper provided by Suntory and Toyota International Centres for Economics and Related Disciplines, LSE in its series STICERD - Econometrics Paper Series with number /2000/395.

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    Date of creation: Jun 2000
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    Handle: RePEc:cep:stiecm:/2000/395

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    Web page: http://sticerd.lse.ac.uk/_new/publications/default.asp

    Related research

    Keywords: Competition; optimal noise; price manipulation;

    References

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    1. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
    2. Bruno Biais & Laurent Germain, 2002. "Incentive-Compatible Contracts for the Sale of Information," Review of Financial Studies, Society for Financial Studies, vol. 15(4), pages 987-1003.
    3. Fishman M. J. & Hagerty K. M., 1995. "The Incentive to Sell Financial Market Information," Journal of Financial Intermediation, Elsevier, vol. 4(2), pages 95-115, April.
    4. Foster, F. Douglas & Viswanathan, S., 1994. "Strategic Trading with Asymmetrically Informed Traders and Long-Lived Information," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(04), pages 499-518, December.
    5. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
    6. Holden, Craig W. & Subrahmanyam, Avanidhar, 1994. "Risk aversion, imperfect competition, and long-lived information," Economics Letters, Elsevier, vol. 44(1-2), pages 181-190.
    7. Biais, Bruno & Martimort, David & Rochet, Jean-Charles, 1998. "Competing Mechanisms in a Commun Value Environment," IDEI Working Papers 75, Institut d'Économie Industrielle (IDEI), Toulouse.
    8. Rochet, J.C. & Vila, J.L., 1993. "Insider Trading Without Normality," Papers 93.b, Toulouse - GREMAQ.
    9. Foster, F Douglas & Viswanathan, S, 1996. " Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-78, September.
    10. Admati, Anat R & Pfleiderer, Paul, 1988. "Selling and Trading on Information in Financial Markets," American Economic Review, American Economic Association, vol. 78(2), pages 96-103, May.
    11. Holden, Craig W & Subrahmanyam, Avanidhar, 1992. " Long-Lived Private Information and Imperfect Competition," Journal of Finance, American Finance Association, vol. 47(1), pages 247-70, March.
    12. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
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