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Informed Trading, Investment, and Welfare

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  • Rohit Rahi

    ()

  • James Dow

Abstract

This paper studies the welfare economics of informed trading in a stock market. We provide a model in which all agents are rational and trade either to exploit information or to hedge risk. We analyze the effect of more informative prices on investment, given that this dependence will itself be reflected in equilibrium prices. Agents understand that asset prices may affect corporate investment decisions, and condition their trades on prices. We present both a general framework, and a parametric version that allows a closed-form solution. We show that in rational expectations equilibrium with price-taking competitive behaviour, and in the presence of risk-neutral uninformed agents, uninformed traders cannot lose money on average to informed traders. However, some agents with superior information may be willing to lose money on average, in order to improve their hedging possibilities. While a higher incidence of informed speculation always increases firm value through a more informative trading process, the effect on agents welfare depends on how revelation of information that agents wish to insure against reduces their hedging opportunities (the Hirshleifer effect). On the other hand, early revelation of information that is uncorrelated with hedging needs allows agents to construct better hedges.

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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp292.pdf
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Bibliographic Info

Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp292.

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Date of creation: Apr 1998
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Handle: RePEc:fmg:fmgdps:dp292

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Web page: http://www.lse.ac.uk/fmg/

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