Manipulation, the allocational role of prices and production externalities

In this paper we show that profitable market manipulation via trade is possible if prices perform an allocational role. If market prices affect the real value of an asset (e.g. because they contain information relevant to a firm's investment decisions), a potentially informed speculator may wish to trade even in the absence of information. A source of profits will then be the effect that his trade has on the real value of the traded asset. We show that the problem is exacerbated if, in the real sector, there are multiple firms with positive investment spillovers. In this case, firm managers who have perfect private information may ignore it and follow the price signal, knowing that other managers are also looking at this signal. Shutting down a financial market may improve investment efficiency in this case. We discuss the implications of our argument to foreign exchange markets.