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Giffen goods and market making

  • Giovanni Cespa

This paper shows that information effects per se are not responsible for the Giffen goods anomaly affecting competitive traders’ demands in multi- asset, noisy rational expectations equilibrium models. The role that information plays in traders’ strategies also matters. In a market with risk averse, uninformed traders, informed agents have a dual motive for trading: speculation and market making. While speculation entails using prices to assess the effect of private signal error terms, market making requires employing them to disentangle noise traders’ effects in traders’ aggregate orders. In a correlated environment, this complicates a trader’s signal-extraction problem and may generate upward-sloping demand curves. Assuming either (i) that competitive, risk neutral market makers price the assets, or that (ii) the risk tolerance coefficient of uninformed traders grows without bound, removes the market making component from informed traders’ demands, rendering them well behaved in prices.

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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 681.

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Date of creation: Apr 2002
Date of revision: May 2003
Handle: RePEc:upf:upfgen:681
Contact details of provider: Web page: http://www.econ.upf.edu/

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  1. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-57, May.
  2. Vives Xavier, 1995. "The Speed of Information Revelation in a Financial Market Mechanism," Journal of Economic Theory, Elsevier, vol. 67(1), pages 178-204, October.
  3. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
  4. Xavier Vives, 1994. "Short-term Investment and the Informational Efficiency of the Market," CEPR Financial Markets Paper 0034, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ..
  5. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  6. Gadi Barlevy & Pietro Veronesi, 2000. "Rational Panics and Stock Market Crashes," CRSP working papers 483, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  7. Gerard Gennotte and Hayne Leland., 1989. "Market Liquidity, Hedging and Crashes," Research Program in Finance Working Papers RPF-192, University of California at Berkeley.
  8. Bhattacharya Utpal & Reny Philip J. & Spiegel Matthew, 1995. "Destructive Interference in an Imperfectly Competitive Multi-Security Market," Journal of Economic Theory, Elsevier, vol. 65(1), pages 136-170, February.
  9. Cespa, Giovanni, 2002. "Short-term investment and equilibrium multiplicity," European Economic Review, Elsevier, vol. 46(9), pages 1645-1670, October.
  10. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
  11. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
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