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Market efficiency and price formation when dealers are asymmetrically informed

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Author Info
Calcagno, R.
Lovo, S.M. (Tilburg University, Center for Economic Research)

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Abstract

We consider the effect of asymmetric information on the price formation process in a quote-driven market where one market maker receives a private signal on the security fundamental. A model is presented where market makers repeatedly compete in prices: at each stage a bid-ask auction occurs and the winner trades the security against liquidity traders. We show that at equilibrium the market is not strong-form efficient until the last stage. We characterize a reputational equilibrium in which the informed market maker will affect market beliefs, and possibly misleads them. At this equilibrium, a price leadership effect arises, quotes are never equal to the expected value of the asset given the public information, the informed market maker expected payoff is positive and the rate of price discovery increases in the last stages of trade before the information becomes public.

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Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 42.

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Date of creation: 2002
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Handle: RePEc:dgr:kubcen:200242

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  3. Harsanyi, John C, 1995. "Games with Incomplete Information," American Economic Review, American Economic Association, vol. 85(3), pages 291-303, June.
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  5. Engelbrecht-Wiggans, Richard & Milgrom, Paul R. & Weber, Robert J., 1983. "Competitive bidding and proprietary information," Journal of Mathematical Economics, Elsevier, vol. 11(2), pages 161-169, April. [Downloadable!] (restricted)
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  7. de Jong, Frank & Mahieu, Ronald J & Schotman, Peter C, 1999. "Price Discovery on Foreign Exchange Markets," CEPR Discussion Papers 2296, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  8. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, vol. 14(1), pages 71-100, March. [Downloadable!] (restricted)
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  9. Aumann, Robert J. & Heifetz, Aviad, 2002. "Incomplete information," Handbook of Game Theory with Economic Applications, in: R.J. Aumann & S. Hart (ed.), Handbook of Game Theory with Economic Applications, edition 1, volume 3, chapter 43, pages 1665-1686 Elsevier. [Downloadable!] (restricted)
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    • Aumann, Robert J. & Heifetz, Aviad, 2001. "Incomplete Information," Working Papers 1124, California Institute of Technology, Division of the Humanities and Social Sciences. [Downloadable!]
  10. Sanford J. Grossman & Joseph E. Stiglitz, 1980. "On the Impossibility of Informationally Efficient Markets," NBER Reprints 0121, National Bureau of Economic Research, Inc.
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  11. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November. [Downloadable!] (restricted)
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  14. Peiers, Bettina, 1997. " Informed Traders, Intervention, and Price Leadership: A Deeper View of the Microstructure of the Foreign Exchange Market," Journal of Finance, American Finance Association, vol. 52(4), pages 1589-1614, September. [Downloadable!] (restricted)
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  16. Calcagno, Riccardo & Lovo, Stefano M., 1998. "Bid-Ask Price Competition with Asymmetric Information between Market Makers," Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) Discussion Paper 1998012, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES). [Downloadable!]
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  17. Bikhchandani, Sushil, 1988. "Reputation in repeated second-price auctions," Journal of Economic Theory, Elsevier, vol. 46(1), pages 97-119, October. [Downloadable!] (restricted)
  18. Huddart, Steven & Hughes, John S & Levine, Carolyn B, 2001. "Public Disclosure and Dissimulation of Insider Trades," Econometrica, Econometric Society, vol. 69(3), pages 665-81, May.
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  20. 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. [Downloadable!] (restricted)
  21. Milgrom, Paul R & Weber, Robert J, 1982. "A Theory of Auctions and Competitive Bidding," Econometrica, Econometric Society, vol. 50(5), pages 1089-1122, September. [Downloadable!] (restricted)
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  22. 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. [Downloadable!] (restricted)
  23. Kreps, David M & Wilson, Robert, 1982. "Sequential Equilibria," Econometrica, Econometric Society, vol. 50(4), pages 863-94, July. [Downloadable!] (restricted)
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  24. Dennert, Jurgen, 1993. "Price Competition between Market Makers," Review of Economic Studies, Blackwell Publishing, vol. 60(3), pages 735-51, July. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Thierry, FOUCAULT & Sophie, MOINAS & Erik, THEISSEN, 2003. "Does anonymity matter in electronic limit order markets ?," Les Cahiers de Recherche 784, Groupe HEC. [Downloadable!]
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