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No 737: Market efficiency and Price Formation when Dealers are Asymmetrically Informed

Stefano M. LOVO and R. CALCAGNO
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R. CALCAGNO: Tilburg University

Abstract: We consider the effect of asymmetric information on price formation process in a quote-driven market where one market maker receives a private signal on the security's fundamental. A model is presented where market makers repeatedly compete in prices: at each stage a bid-ask auction occurs and the winner trades the security against liquidity traders. We show that at equilibrium the market is not strong-form efficient until the last stage. We characterize a reputational equilibrium in which the informed market maker will aspect market beliefs, possibly misleading them, in the sense that he will push the uninformed participants to think the value of the risky asset is different from the realized one. At this equilibrium a price leadership effect arises, quotes are never equal to the expected value of the asset given the public information, the informed market maker expected payoff is positive and the information revelation speed is slower than in an analogous order-driven market.

Keywords: bid-ask prices; asymmetric information; repeated auction; insider trading

JEL-codes: G14

42 pages, November 16, 2001

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