Paper #681

Title:

Giffen goods and market making

Author:

Giovanni Cespa

Date:

April 2002 (Revised: May 2003)

Abstract:

This paper shows that information effects per se are not responsible for the Giffen goods anomaly affecting competitive traders’ demands in multi- asset, noisy rational expectations equilibrium models. The role that information plays in traders’ strategies also matters. In a market with risk averse, uninformed traders, informed agents have a dual motive for trading: speculation and market making. While speculation entails using prices to assess the effect of private signal error terms, market making requires employing them to disentangle noise traders’ effects in traders’ aggregate orders. In a correlated environment, this complicates a trader’s signal-extraction problem and may generate upward-sloping demand curves. Assuming either (i) that competitive, risk neutral market makers price the assets, or that (ii) the risk tolerance coefficient of uninformed traders grows without bound, removes the market making component from informed traders’ demands, rendering them well behaved in prices.

Keywords:

Financial economics, asset pricing, information and market efficiency

JEL codes:

G100, G120, G140

Area of Research:

Finance and Accounting

Published in:

Economic Theory, 2005, vol. 25, 983-997

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