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Journal ArticleDOI

The Trader's Dilemma: Trading Strategies and Endogenous Pricing in an Illiquid Market

TL;DR: In this article, the authors investigate a large trader's trading strategies in a decentralized market, in which all traders are subject to type switching and derive subgame perfect equilibria under three different spot market structures.
Abstract: We investigate a large trader's trading strategies in a decentralized market, in which all traders are subject to type switching. The large trader has pressure to liquidate her position by the end of the horizon to avoid extra holding costs. She faces a trade-off: if she trades quickly, she moves the price too much; if she trades slowly, she may not be able to find counterparties in the market in later periods. We derive subgame perfect equilibria under three different spot market structures. The structures are chosen to show various degrees of competitive bargaining. We show that in each equilibrium the large trader chooses the optimal trading strategy to take into account both the price impact effect and liquidity uncertainty. Thus asset prices are generated endogenously through a dynamic bargaining and trading process and reflect the impact of the large trader's trades. Small traders, who possess little market power, cannot be ignored because their reactions to the large trader's trading strategy jointly determines market liquidity. We show that limiting competitive pricing occurs when there are enough small traders, or there are many trading periods. Illiquidity is generated by the thin market for buyers, and their limited capacity to buy the asset sold by the large trader.

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Posted Content
01 Jan 2008
TL;DR: In this article, the authors investigated market manipulation trading strategies by large traders in the stock market and provided sufficient conditions for their nonexistence under a reasonable hypothesis on the equilibrium price process.
Abstract: This paper investigates market manipulation trading strategies by large traders in a securities market. A large trader is defined as any investor whose trades change prices. A market manipulation trading strategy is one that generates positive real wealth with no risk. Market manipulation trading strategies are shown to exist under reasonable hypotheses on the equilibrium price process. Sufficient conditions for their nonexistence are also provided.

39 citations

Posted Content
TL;DR: In this article, a dynamic model of a financial market with a strategic trader was studied, where the strategic trader receives a privately observed endowment in the stock market and trades with competitive market makers to share risk.
Abstract: This paper studies a dynamic model of a nancial market with a strategic trader. In each period the strategic trader receives a privately observed endowment in the stock. He trades with competitive market makers to share risk. Noise traders are present in the market. After receiving a stock endowment, the strategic trader is shown to reduce his risk exposure either by selling at a decreasing rate over time, or by selling and then buying back some of the shares sold. When the time between trades is small, the strategic trader reveals the information regarding his endowment very quickly.

9 citations

Journal ArticleDOI
TL;DR: In this paper, the authors investigate the impact of an arbitrageur's activities in an illiquid market, where there is a large distressed trader and a fringe of small traders, and they find that equilibrium strategies for large traders vary with their relative bargaining power and the level of uncertainty with respect to market liquidity.
Abstract: We investigate the impact of an arbitrageur's activities in an illiquid market, where there is a large distressed trader and a fringe of small traders. Large traders trade strategically considering price impacts of their trades and future uncertainty on market liquidity. Prices are determined endogenously through a dynamic bar-gaining and trading process. We find that equilibrium strategies for large traders vary with their relative bargaining power and the level of uncertainty with respect to market liquidity. When there is no such uncertainty, the arbitrageur does not trade at all. However, when there is even a slight amount of uncertainty over future liquidity, the arbitrageur may want to sell part of her holdings before the distressed trader. Moreover, her incentive to "front-run" increases with the level of uncertainty. In most cases, the arbitrageur will front-run the distressed trader by selling quickly, and rebuild her position later at a lower price. The distressed trader's optimal response is to liquidate quickly, despite a big price decline. We note, however, that the arbitrageur does not front-run when there is little uncertainty over market liquidity, or when market liquidity improves over time. The distressed seller can then trade quickly without disturbing prices dramatically.

5 citations

References
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Journal ArticleDOI

9,341 citations


"The Trader's Dilemma: Trading Strat..." refers background or methods in this paper

  • ...Among efforts to achieve a definition, Kyle (1985) provides a thorough characterization of “market liquidity”, which is widely accepted by academics and practitioners....

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  • ...This distinguishes our model from many market microstructure models, such as Kyle (1985) and others, in which the information asymmetry is the major incentive for some market participants to trade strategically....

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  • ...…and Vila (1999), Huang (2003), Duffie, Garleanu and Pederson (2003, 2004)], or stochastic [Acharya and Pederson (2004)] and asymmetric information [Kyle (1985, 1989), Vayanos 1 For example, Holthausen, Leftwich and Mayers (1990) examine price effects associated with block trades by investigating…...

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  • ...For example, we show that even without asymmetric information [Kyle (1985)] or the need to share risk [Vayanos (1999, 2001)] large traders still trade strategically when the market is incomplete and illiquid....

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Journal ArticleDOI
TL;DR: In this article, the effect of the bid-ask spread on asset pricing was studied and it was shown that market-observed expexted return is an increasing and concave function of the spread.

4,129 citations

Journal ArticleDOI
TL;DR: In this paper, the authors study how intermediation and asset prices in over-the-counter markets are aected by illiquidity associated with search and bargaining, and compute explicitly the prices at which investors trade with each other as well as marketmakers' bid and ask prices in a dynamic model with strategic agents.
Abstract: We study how intermediation and asset prices in over-the-counter markets are aected by illiquidity associated with search and bargaining. We compute explicitly the prices at which investors trade with each other as well as marketmakers’ bid and ask prices in a dynamic model with strategic agents. Bid-ask spreads are lower if investors can more easily nd other investors, or have easier access to multiple marketmakers. With a monopolistic marketmaker, bid-ask spreads are higher if investors have easier access to the marketmaker. We characterize endogenous search and welfare, and discuss empirical implications.

1,066 citations

Journal ArticleDOI
TL;DR: In this article, a two-asset, intertemporal portfolio selection model incorporating proportional transaction costs is formulated, and the demand for assets is shown to be sensitive to these costs.
Abstract: A two-asset, intertemporal portfolio selection model is formulated incorporating proportional transaction costs. The demand for assets is shown to be sensitive to these costs. However, transaction ...

968 citations

Journal ArticleDOI
TL;DR: In contrast to the competitive model, a reasonable model of endogenous acquisition of costly private information is obtained, even when traders are risk-neutral as discussed by the authors, and prices reveal less information than in the competition equilibrium.
Abstract: Competitive rational expectations models have the unsatisfactory property, dubbed the "schizophrenia" problem by Hellwig, that each trader takes the equilibrium price as given despite the fact that he influences that price An examination of information aggregation in a non-competitive rational expectations model using a Nash equilibrium in demand functions shows that the schizophrenia problem is avoided by having each trader take into account the effect his demand has on the equilibrium price Given a distribution of private information across traders, prices reveal less information than in the competition equilibrium, and prices no longer become fully informative in the limit as noise trading vanishes or as traders become risk neutral With small traders, the model may become one of monopolistic competition, not perfect competition In contrast to the competitive model, a reasonable model of endogenous acquisition of costly private information is obtained, even when traders are risk-neutral

872 citations


"The Trader's Dilemma: Trading Strat..." refers background in this paper

  • ...…and Vila (1999), Huang (2003), Duffie, Garleanu and Pederson (2003, 2004)], or stochastic [Acharya and Pederson (2004)] and asymmetric information [Kyle (1985, 1989), Vayanos 1 For example, Holthausen, Leftwich and Mayers (1990) examine price effects associated with block trades by investigating…...

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