A Baseline Model of Price Formation in a Sequential Market

Abstract

In a centralized market where information over the fundamental value of a traded asset is asymmetric and imperfect a basic question arises: how well the market price transmits and aggregates disperse information. We address this using the trading protocol of Glosten and Milgrom (1985) but in an environment where ex ante symmetric agents have interdependent valuations, and affiliated private information. This implies that traders are informationally equivalent, and that there are neither pure liquidity-driven traders nor pure speculators. We show several properties of the ask and bid prices, but most importantly we prove that both prices in the limit collapse to a single value (the limiting price) which reveals the fundamental value of the asset. Adverse selection, which is inherent in the model, does not impede the estimation problem in the sense that the rate of convergence to the limiting price is the same as that of a fully signal-revealing mechanism.

Keywords: Information Aggregation, Market Microstructure, Sequential Markets, Bid-ask Spread, Convergence Rates, Interdependent Values

JEL Classification: D82, D83, G14