Informed Trading, Investment, and Welfare

Abstract

This paper studies the welfare economics of informed trading in a stock market. We model the effect of more informative prices on investment, given that this dependence will itself be reflected in equilibrium prices. We show that in rational expectations equilibrium with price-taking competitive behavior, and in the presence of risk-neutral uninformed agents, uninformed traders cannot lose money on average to informed traders. However, some agents with superior information may be willing to lose money on average in order to improve their hedging possibilities. We provide a parametric model that allows a closed-form solution and a complete welfare analysis. While a higher incidence of informed speculation always increases firm value through a more informative trading process, the effect on agents' welfare depends on how revelation of information changes risk-sharing opportunities in the market.

JEL Classification: G10