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Giffen goods and market making

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  • Giovanni Cespa

Abstract

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.

Suggested Citation

  • Giovanni Cespa, 2002. "Giffen goods and market making," Economics Working Papers 681, Department of Economics and Business, Universitat Pompeu Fabra, revised May 2003.
  • Handle: RePEc:upf:upfgen:681
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    References listed on IDEAS

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    1. 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.
    2. Cespa, Giovanni, 2002. "Short-term investment and equilibrium multiplicity," European Economic Review, Elsevier, vol. 46(9), pages 1645-1670, 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. Barlevy, Gadi & Veronesi, Pietro, 2003. "Rational panics and stock market crashes," Journal of Economic Theory, Elsevier, pages 234-263.
    5. Gennotte, Gerard & Leland, Hayne, 1990. "Market Liquidity, Hedging, and Crashes," American Economic Review, American Economic Association, vol. 80(5), pages 999-1021, December.
    6. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
    7. Vives, Xavier, 1995. "Short-Term Investment and the Informational Efficiency of the Market," Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 125-160.
    8. 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.
    9. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    10. 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.
    11. Admati, Anat R, 1985. "A Noisy Rational Expectations Equilibrium for Multi-asset Securities Markets," Econometrica, Econometric Society, vol. 53(3), pages 629-657, May.
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    Cited by:

    1. Cespa, Giovanni & Vives, Xavier, 2011. "Expectations, Liquidity, and Short-term Trading," CEPR Discussion Papers 8303, C.E.P.R. Discussion Papers.
    2. Giovanni Cespa & Xavier Vives, 2015. "The Beauty Contest and Short-Term Trading," Journal of Finance, American Finance Association, vol. 70(5), pages 2099-2154, October.
    3. Giovanni Cespa, 2003. "A comparison of stock market mechanisms," Working Papers 50, Barcelona Graduate School of Economics.

    More about this item

    Keywords

    Financial economics; asset pricing; information and market efficiency;

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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