As part of the series of the „Finance Research Seminar“, VGSF welcomes James Dow from London Business School to present his research paper.
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Paper
Does Informed Trading Enhance or Impair Market Liquidity?
(joint with Jungsuk Han and Francesco Sangiorgi)
A common (mis?) conception is that informed traders reduce liquidity by driving out uninformed trade, through a “lemons” or “cream-skimming” effect. However, this is an oversimplification. The lemons effect is offset by another effect, the “endogenous asymmetric information effect.” Informed traders may indeed deter uninformed traders by making money at their expense, and this can reduce trading by uninformed traders (lemons effect). But there is another, opposite, effect: more informed trade tends to make prices more informative. Therefore, in equilibrium the amount of asymmetric information, conditional on the price (or on all information that traders can condition on), is smaller than before trading commenced. In turn, this reduces the monetary transfer from uninformed to informed traders, and tends to increase trading by uninformed traders. We call this the endogenous asymmetric information effect. The endogenous asymmetric information effect may outweigh the lemons effect: more informed traders may end up encouraging more uninformed trade.
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