Strategic Trading and Welfare in a Dynamic Market (Q4262871)

The paper analyzes a dynamic model of a financial market with large agents who trade to share risk. The questions investigated are the following: what trading strategies do the large agents follow to minimize the price impact of their decision? What influences market liquidity? Finally, how small is the fraction of gains of trade lost because of strategic behavior. More specifically, a discrete time infinite horizon economy with a consumption good and two investment opportunities; the first of which is a riskless technology and the second a risky stock; the only agents are \(N\) infinitely lived risk averse large traders who receive random stock endowments in each period and trade to share dividend risk. The endowments constitute the only private information. It is shown that agents trade slowly even when the time between trades go to zero; also, welfare loss due to strategic behavior increases as the time between trades decreases; in the limit, when the time goes to zero welfare is of the order \(1/N\) and not \(1/N^2\), as in the double auction literature. Apart from this literature, results obtained may be related two more areas: the market microstructure literature and the durable goods monopoly literature. The relationship to the former arises out of the asset trading process; the relationship with the latter area due to the fact that both the large traders and the durable goods monopolists delay trades in order to practice price discrimination.