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Informed Trading, Investment, and Welfare

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Author Info
Rohit Rahi ()
James Dow

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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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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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  1. James Dow & Itay Goldstein & Alexander Guembel, 2005. "Commitment to Overinvest and Price Informativeness," OFRC Working Papers Series 2005fe18, Oxford Financial Research Centre. [Downloadable!]
  2. Wassim Daher & Leonard J. Mirman, 2004. "Market structure and insider trading," Cahiers de la Maison des Sciences Economiques b04025, Université Panthéon-Sorbonne (Paris 1). [Downloadable!]
    Other versions:
  3. Alexander Gümbel, 2000. "Myopic Traders, Efficiency and Taxation," OFRC Working Papers Series 2000fe05, Oxford Financial Research Centre. [Downloadable!]
  4. Itay Goldstein & Alexander Gümbel, 2002. "Manipulation, the allocational role of prices and production externalities," OFRC Working Papers Series 2002fe02, Oxford Financial Research Centre. [Downloadable!]
  5. Giovanni Cespa, 2003. "A Comparison of Stock Market Mechanisms," CSEF Working Papers 94, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy. [Downloadable!]
    Other versions:
  6. Foucault, Thierry & Cespa, Giovanni, 2008. "Insiders-outsiders, transparency and the value of the ticker," Les Cahiers de Recherche 892, HEC Paris. [Downloadable!]
    Other versions:
  7. James Dow & Gary Gorton, 2006. "Noise Traders," NBER Working Papers 12256, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Sciubba, E., 1999. "Asymmetric Information and Survival in Financial Markets," Cambridge Working Papers in Economics 9908, Faculty of Economics, University of Cambridge. [Downloadable!]
    Other versions:
  9. Alexander Gümbel, 2005. "Should short-term speculators be taxed, or subsidised?," Annals of Finance, Springer, vol. 1(3), pages 327-348, 08. [Downloadable!] (restricted)
  10. José M. Marín & Rohit Rahi, 1997. "Speculative Securities," Economics Working Papers 223, Department of Economics and Business, Universitat Pompeu Fabra. [Downloadable!]
    Other versions:
  11. Juan Dubra & Helios Herrera, 2002. "Market Participation, Information and Volatility," Working Papers 0206, Centro de Investigacion Economica, ITAM. [Downloadable!]
  12. Andrea Buffa & Giovanna Nicodano, 2006. "Should Insider Trading be Prohibited when Share Repurchases are Allowed?," Carlo Alberto Notebooks 16, Collegio Carlo Alberto. [Downloadable!]
    Other versions:
  13. Perotti, Enrico C & Rossetto, Silvia, 2007. "Unlocking Value: Equity Carve outs as Strategic Real Options," CEPR Discussion Papers 6268, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  14. Wassim Daher & Leonard J. Mirman, 2004. "Cournot duopoly and insider trading with two insiders," Cahiers de la Maison des Sciences Economiques b04077, Université Panthéon-Sorbonne (Paris 1). [Downloadable!]
    Other versions:
  15. Gao, Pingyang, 2008. "Disclosure Quality, Cost of Capital, and Investors’ Welfare," MPRA Paper 9478, University Library of Munich, Germany, revised Jun 2008. [Downloadable!]
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