Asset trading with informed price makers

The present paper analyses existence and structure of revealing equilibria of a game which models the asset-trading interaction between a risk-neutral informed price-making agent and an uninformed one. The trade-off in the problem faced by the uninformed turns out to be between losing smaller amounts with higher probabilityand losing larger amounts with lower probability. This balance is governed by downside risk aversion (positive third derivative of vNM utilityfunction). Asymmetric information and risk aversion notwithstanding, the downside-risk neutral uninformed (quadratic utility) always gets a fair price on the bet he enters in the revealing equilibrium, corresponding to the expected value of the asset conditional on full information. On the contrary, the downside-risk averse uninformed always pays more than the above expected value. This conclusion is our counterpart of that reached by Glosten-Milgrom (1985) and Kyle (1985), who consider uninformed agents trading with uninformed price-making dealers: there the uninformed traders bear a negative externalityexerted bythe informed traders; here theyen ter unfair bets because of their own downside risk aversion. It is argued that the present model applies more closely to European stock markets.