Public Information and Uninformed Trading: Implications for Market Liquidity and Price Efficiency
66 Pages Posted: 11 Sep 2014 Last revised: 26 Feb 2016
Date Written: January 2016
We develop a rational expectations equilibrium model in which noise trading comes from discretionary liquidity traders. The equilibrium quantity of aggregate noise trading is endogenously determined by the population size of liquidity traders active in the financial market. By improving market liquidity, public information reduces the expected trading loss of liquidity traders and thus attracts more such traders to the market, which negatively affects information aggregation. Analyzing an alternative setting that models noise trading as coming from hedgers yields similar insights. In a setting with endogenous information, public information can harm information aggregation both through crowding out private information and through attracting noise trading.
Keywords: Discretionary liquidity trading, market liquidity, information aggregation, information production, hedging
JEL Classification: D61, G14, G30, M41
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