Information Acquisition in a Limit Order Market

47 Pages Posted: 7 Jan 2005

See all articles by Ronald L. Goettler

Ronald L. Goettler

University of Rochester - Simon School of Business

Christine A. Parlour

University of California, Berkeley - Finance Group

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: December 22, 2004

Abstract

We model endogenous information acquisition in a limit order market for a single financial asset. The asset has a common value; in addition, each trader has a private value for it. Traders randomly arrive at the market, after choosing whether to purchase information about the common value. They may either post prices or accept posted prices. If a trader's order has not executed, he randomly reenters the market, and may change his previous order. The model is thus a dynamic stochastic game with asymmetric information. We numerically solve for the equilibrium of the trading game, and characterize equilibria with endogenous information acquisition. Over a range of information acquisition costs, the game exhibits a prisoner's dilemma - all agents, including those who acquire information, are worse off. Agents with the lowest intrinsic benefit from trade have the highest value for information and also tend to supply liquidity. As a result, market observables such as bid and ask quotes, in addition to transaction prices, are informative about the common value of the asset. Adverse selection is important for individuals (agents have lower payoffs when uninformed), but in the aggregate it has little effect on investor surplus, unless gains to trade are small. Comparisons to a frictionless benchmark show that the limit order market is effective at consummating trade and generating consumer surplus, even in the presence of asymmetric information.

Keywords: adverse selection, allocative efficiency, informational efficiency, dynamic games, limit order market

JEL Classification: C73, D82, G14

Suggested Citation

Goettler, Ronald L. and Parlour, Christine A. and Rajan, Uday, Information Acquisition in a Limit Order Market (December 22, 2004). EFA 2005 Moscow Meetings Paper, Fifteenth Annual Utah Winter Finance Conference, Available at SSRN: https://ssrn.com/abstract=644325 or http://dx.doi.org/10.2139/ssrn.644325

Ronald L. Goettler (Contact Author)

University of Rochester - Simon School of Business ( email )

Rochester, NY 14627
United States

Christine A. Parlour

University of California, Berkeley - Finance Group ( email )

Haas School of Business
545 Student Services Building
Berkeley, CA 94720
United States
510-643-9391 (Phone)

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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