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Informed trading, investment, and welfare

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  • Dow, James
  • Rahi, Rohit

Abstract

This paper studies the welfare economics of informed trading in a stock market. We provide a model in which all agents are rational and trade either to exploit information or to hedge risk. We analyze the effect of more informative prices on investment, given that this dependence will itself be reflected in equilibrium prices. Agents understand that asset prices may affect corporate investment decisions, and condition their trades on prices. We present both a general framework, and a parametric version that allows a closed-form solution. We show that in rational expectations equilibrium with price-taking competitive behaviour, and in the presence of risk-neutral uninformed agents, uninformed traders cannot lose money on average to informed traders. However, some agents with superior information may be willing to lose money on average in order to improve their hedging possibilities. While a higher incidence of informed speculation always increases firm value through a more informative trading process, the effect on agents' welfare depends on how revelation of information changes risk-sharing opportunities in the market. Greater revelation of information that agents wish to insure against reduces their hedging opportunities (the Hirshleifer effect). On the other hand, early revelation of information that is uncorrelated with hedging needs allows agents to construct better hedges.

Suggested Citation

  • Dow, James & Rahi, Rohit, 1998. "Informed trading, investment, and welfare," LSE Research Online Documents on Economics 119147, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119147
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    File URL: http://eprints.lse.ac.uk/119147/
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    References listed on IDEAS

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    More about this item

    Keywords

    speculation; information revelation; feedback effect; market-maker;
    All these keywords.

    JEL classification:

    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D60 - Microeconomics - - Welfare Economics - - - General

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