Welfare Costs of Informed Trade

44 Pages Posted: 23 Aug 2016  

Lawrence R. Glosten

Columbia Business School - Finance and Economics

Tālis J. Putniņš

University of Technology Sydney (UTS) - Faculty of Business; Stockholm School of Economics, Riga; Financial Research Network (FIRN)

Date Written: July 7, 2016

Abstract

We examine the welfare costs of informed trade in a new Glosten-Milgrom type model with elastic uninformed trade. Welfare losses occur when uninformed agents choose not to trade because their idiosyncratic valuation lies within the bid-ask spread. Informed trade causes wider spreads initially, but narrower spreads later because information is reflected in prices faster. For sufficiently long lived information, the benefits of narrow spreads later outweigh the wider initial spreads such that the average spread and total welfare loss are mainly decreasing in the amount of informed trade. For short-lived information, this tradeoff does not materialize and spreads and welfare losses are increasing in informed trade. Our findings suggest that regulation of information and informed trade should consider the horizon of private information.

Keywords: market microstructure, welfare, liquidity, informed trading, insider trading

JEL Classification: G14, K22

Suggested Citation

Glosten, Lawrence R. and Putnins, Talis J., Welfare Costs of Informed Trade (July 7, 2016). AFA 2016 San Francisco Meetings; Columbia Business School Research Paper No. 16-58. Available at SSRN: https://ssrn.com/abstract=2827158 or http://dx.doi.org/10.2139/ssrn.2827158

Lawrence R. Glosten

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

Talis J. Putnins (Contact Author)

University of Technology Sydney (UTS) - Faculty of Business ( email )

PO Box 123
Broadway
Sydney
Australia
+61 2 9514 3088 (Phone)

Stockholm School of Economics, Riga ( email )

Strelnieku iela 4a
Riga, LV 1010
Latvia
+371 67015841 (Phone)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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