Paper #238

Title:

Strategic behavior and price discovery

Authors:

Luis A. Medrano and Xavier Vives

Date:

September 1997

Abstract:

The paper analyzes the effects of strategic behavior by an insider in a price discovery process, akin to an information tatonnement, in the presence of a competitive informed sector. Such processes are used in the preopening period of continuous trading systems in several exchanges. It is found that the insider manipulates the market using a contrarian strategy in order to neutralize the effect of the trades of competitive informed agents. Furthermore, consistently with the empirical evidence available, we find that information revelation accelerates close to the opening, that the market price does not converge to the fundamental value no matter how many rounds the tatonnement has, and that the expected trading volume displays a U-shaped pattern. We also find that a market with a larger competitive sector (smaller insider) has an improved informational efficiency and an increased trading volume. The insider provides a public good (a lower informativeness of the price) for the competitive informed sector.

Keywords:

Market manipulation, contrarian behavior, preopening auction, information atonnement, market microestructure, insider trading

JEL codes:

D82,G12,G14

Area of Research:

Finance and Accounting

Published in:

Rand Journal of Economics, 32, 221-248, 2001

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