Admati And Pfleiderer-A Theory Of Intraday Patterns - Volume And Price Variability

We believe that the inclusion of these traders

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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 liquidity traders. 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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