Informed Trading, Investment, and Welfare*

Abstract

This paper studies the welfare economics of informed trading in a stock market. We model the effect of more informative prices on investment, given that this dependence will itself be reflected in equilibrium prices. 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. We provide a parametric model that allows a closed-form solution and a complete welfare analysis. 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.

Speculation and Hedging in Segmented Markets

“…Glosten (1989), Spiegel and Subrahmanyam (1992), Dow and Rahi (2003), Goldstein and Guembel (2008) and Kyle, Ou-Yang, and Wei (2011), among others, study Kyle (1985)-type models with endogenous noise trading generated from risk-averse uninformed hedgers who hedge their endowment at University of Pennsylvania Library on April 13, 2014 http://rfs.oxfordjournals.org/ Downloaded from risk optimally. Similar formulations of hedging motives also appear in Grossman-Stiglitz (1980)-type models-for example, Duffie and Rahi (1995), Lo, Mamaysky, and Wang (2004), Watanabe (2008), Biais, Bossaerts, and Spatt (2010) and Huang and Wang (2010).…”

Herd Behavior and Contagion in Financial Markets

“…7 Therefore, they have a non-informational motive to trade, since they need to hedge the risk of the non-tradable payoff. Similarly, in Dow and Rahi (2003), traders have a non-informational reason to trade as they hedge the risk stemming from a stochastic endowment. Such a non-informational reason to trade is summarized in our model by the private component of the asset value.…”

“…In an economy with homogenous agents, during an informational cascade, all agents choose the same action, that is, they herd. 23 In our economy, because of trader heterogeneity, uniformity of actions only occurs for traders of the same type. In particular, during a cascade, all informed traders with the same private value choose the same action, either conforming to the established pattern of trade or going against it.…”

Disclosure Quality, Cost of Capital, and Investors' Welfare

“…Verrecchia (1982) and Watts (1982) survey this early literature. See also Holmstrom and Tirole (1993) and Dow and Rahi (2003) for the concern of the adverse welfare effect of public information in models in economics and finance. 3 See Verrecchia (2001) and Dye (2001) for an inspiring discussion about the development of the literature.…”