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Long-term Information, Short-lived Securities

Author

Listed:
  • Dan Bernhardt

    (University of Illinois, USA)

  • Ryan J. Davies

    () (ICMA Centre, University of Reading)

  • John Spicer

    (European Economic Research Ltd, London)

Abstract

We explore strategic trade in short-lived securities by agents who possess long-term information. Trading short-lived securities is profitable only if enough of the private information becomes public prior to contract expiration; otherwise the security will worthlessly expire. We highlight how this results in trading behavior fundamentally different from that observed in standard models of informed trading in equity. Specifically, we show that informed agents are more reluctant to trade shorter-term securities too far in advance of when their information will necessarily be made public, and that existing positions in a shorter-term security make future purchases more attractive. Because informed agents prefer longer-term securities, this can make trading shorter-term contracts more attractive for liquidity traders. We characterize the conditions under which liquidity traders choose to incur extra costs to roll over short-term positions rather than trade in distant contracts, providing an explanation for why most longer-term derivative security markets have little liquidity and large bid-ask spreads.

Suggested Citation

  • Dan Bernhardt & Ryan J. Davies & John Spicer, 2003. "Long-term Information, Short-lived Securities," ICMA Centre Discussion Papers in Finance icma-dp2003-10, Henley Business School, Reading University.
  • Handle: RePEc:rdg:icmadp:icma-dp2003-10
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    File URL: http://www.icmacentre.ac.uk/pdf/discussion/DP2003-10.pdf
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    References listed on IDEAS

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    1. Dow, James & Gorton, Gary, 1994. " Arbitrage Chains," Journal of Finance, American Finance Association, vol. 49(3), pages 819-849, July.
    2. Neuberger, Anthony, 1999. "Hedging Long-Term Exposures with Multiple Short-Term Futures Contracts," Review of Financial Studies, Society for Financial Studies, vol. 12(3), pages 429-459.
    3. Seppi, Duane J, 1990. " Equilibrium Block Trading and Asymmetric Information," Journal of Finance, American Finance Association, vol. 45(1), pages 73-94, March.
    4. Michael Fleming & Asani Sarkar, 1999. "Liquidity in U.S. Treasury Spot and Futures Markets," CGFS Papers chapters,in: Bank for International Settlements (ed.), Market Liquidity: Research Findings and Selected Policy Implications, volume 11, pages 1-14 Bank for International Settlements.
    5. Kerry Back & C. Henry Cao & Gregory A. Willard, 2000. "Imperfect Competition among Informed Traders," Journal of Finance, American Finance Association, vol. 55(5), pages 2117-2155, October.
    6. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-738, August.
    7. Foster, F. Douglas & Viswanathan, S., 1994. "Strategic Trading with Asymmetrically Informed Traders and Long-Lived Information," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(04), pages 499-518, December.
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    Cited by:

    1. Chris Brooks & Ryan J. Davies & Sang Soo Kim, 2005. "Cross Hedging with Single Stock Futures," ICMA Centre Discussion Papers in Finance icma-dp2004-15, Henley Business School, Reading University.

    More about this item

    Keywords

    Priviate information; derivative securities; rolling the hedge; fixed transaction costs;

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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