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Market efficiency and Price Formation when Dealers are Asymmetrically Informed

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Author Info

  • LOVO, Stefano M.
  • CALCAGNO, R.

    (Tilburg University)

Abstract

We consider the effect of asymmetric information on price formation process in a quote-driven market where one market maker receives a private signal on the security's 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 aspect market beliefs, possibly misleading them, in the sense that he will push the uninformed participants to think the value of the risky asset is different from the realized one. 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 information revelation speed is slower than in an analogous order-driven market.

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Bibliographic Info

Paper provided by HEC Paris in its series Les Cahiers de Recherche with number 737.

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Length: 42 pages
Date of creation: 16 Nov 2001
Date of revision:
Handle: RePEc:ebg:heccah:0737

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Keywords: bid-ask prices; asymmetric information; repeated auction; insider trading;

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References

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  1. Holden, Craig W & Subrahmanyam, Avanidhar, 1992. " Long-Lived Private Information and Imperfect Competition," Journal of Finance, American Finance Association, American Finance Association, vol. 47(1), pages 247-70, March.
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  7. Mertens, J.-F., 1986. "Repeated games," CORE Discussion Papers, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) 1986024, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
  8. de Jong, Frank & Mahieu, Ronald J & Schotman, Peter C, 1999. "Price Discovery on Foreign Exchange Markets," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2296, C.E.P.R. Discussion Papers.
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  14. Cordella, Tito & Foucault, Thierry, 1997. "Minimum Price Variations, Time Priority and Quote Dynamics," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1717, C.E.P.R. Discussion Papers.
  15. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1315-35, November.
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  21. Kyle, Albert S, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 56(3), pages 317-55, July.
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Cited by:
  1. Foucault, Thierry & Moinas, Sophie & Theissen, Erik, 2005. "Does anonymity matter in electronic limit order markets?," CFR Working Papers, University of Cologne, Centre for Financial Research (CFR) 05-15, University of Cologne, Centre for Financial Research (CFR).

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