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Unformatted text preview: ed. We believe that
the inclusion of these traders captures an important element of actual
trading in financial markets. We will demonstrate that the behavior of
liquidity traders, together with that of potentially informed speculators
who may trade on the basis of private information they acquire, can explain
some of the empirical observations mentioned above as well as suggest
some new testable predictions.
It is intuitive that, to the extent that liquidity traders have discretion over
when they trade, they prefer to trade when the market is “thick”—that is,
when their trading has little effect on prices. This creates strong incentives
for liquidity traders to trade together and for trading to be concentrated.
When informed traders can also decide when to collect information and
when to trade, the story becomes more complicated. Clearly, informed
traders also want to trade when the market is thick. If many informed
traders trade at the same time that liquidity traders concentrate their trading, then the terms of trade will reflect the increased level of informed
trading as well, and this may conceivably drive out the liquidity traders.
It is not clear, therefore, what patterns may actually emerge.
In fact, we show in our model that as long as there is at least one informed
trader, the introduction of more informed traders generally intensifies the
forces leading to the concentration of trading by discretionary liquidity
traders. This is because informed traders compete with each other, and
this typically improves the welfare of liquidity traders. We show that liquidity traders always benefit from more entry by informed traders when
informed traders have the same information. However, when the information of each informed trader is different (i.e., when information is diverse
among informed traders), then this may not be true. As more diversely
informed traders enter the market, the amount of information that is available to the market as a whole increases, and this may worsen the terms of
trade for everyone. Despite this possibility, we show that with diversely
informed traders the patterns that generally emerge involve a concentration of trading.
The trading model used in our analysis is in the spirit of Glosten and
Milgrom (1985) and especially Kyle (1984, 1985). Informed traders and
liquidity traders submit market orders to a market maker who sets prices
so that his expected profits are zero given the total order flow. The information structure in our model is simpler than Kyle (1985) and Glosten
and Milgrom (1985) in that private information is only useful for one
period. Like Kyle (1984, 1985) and unlike Glosten and Milgrom (1985),
orders are not constrained to be of a fixed size such as one share. Indeed,
the size of the order is a choice variable for traders.
What distinguishes our analysis from these other papers is that we examine, in a simple dynamic context, the interaction between strategic informed
traders and strategic liquidity traders. Specifically, our models include two types of liquidity traders. Nondiscretionary liquidity traders must trade a
particular number of shares at a particular time (for reasons that are not
modeled). In addition, we assume that there are some discretionary liquidity traders, who also have liquidity demands, but who can be strategic
in choosing when to execute these trades within a given period of time,
e.g., within 24 hours or by the end of the trading day. It is assumed that
discretionary liquidity traders time their trades so as to minimize the
(expected) cost of their transactions.
Kyle (1984) discusses a single period version of the model we use and
derives some comparative statics results that are relevant to our discussion.
In his model, there are multiple informed traders who have diverse information. There are also multiple market makers, so that the model we use
is a limit of his model as the number of market makers grows. Kyle (1984)
discusses what happens to the informativeness of the price as the variance
of liquidity demands changes. He shows that with a fixed number of informed
traders the informativeness of the price does not depend on the variance
of liquidity demand. However, if information acquisition is endogenous,
then price informativeness is increasing in the variance of the liquidity
demands, These properties of the single period model play an important
role in our analysis, where the variance of liquidity demands in different
periods is determined in equilibrium by the decisions of the discretionary
We begin by analyzing a simple model that involves a fixed number of
informed traders, all of whom observe the same information. Discretionary
liquidity traders can determine the timing of their trade, but they can trade
only once during the time period within which they must satisfy their
liquidity demand. (Such a restriction may be motivated by per-trade transaction costs.) We show that in this model there will be patterns in the
volume of trade; namely, trade will tend to be co...
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- Spring '12