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Information and Learning in Markets

Information and Learning in Markets: The Impact of Market Microstructure

Xavier Vives
Copyright Date: 2008
Edition: STU - Student edition
Pages: 424
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  • Book Info
    Information and Learning in Markets
    Book Description:

    The ways financial analysts, traders, and other specialists use information and learn from each other are of fundamental importance to understanding how markets work and prices are set. This graduate-level textbook analyzes how markets aggregate information and examines the impacts of specific market arrangements--or microstructure--on the aggregation process and overall performance of financial markets. Xavier Vives bridges the gap between the two primary views of markets--informational efficiency and herding--and uses a coherent game-theoretic framework to bring together the latest results from the rational expectations and herding literatures.

    Vives emphasizes the consequences of market interaction and social learning for informational and economic efficiency. He looks closely at information aggregation mechanisms, progressing from simple to complex environments: from static to dynamic models; from competitive to strategic agents; and from simple market strategies such as noncontingent orders or quantities to complex ones like price contingent orders or demand schedules. Vives finds that contending theories like informational efficiency and herding build on the same principles of Bayesian decision making and that "irrational" agents are not needed to explain herding behavior, booms, and crashes. As this book shows, the microstructure of a market is the crucial factor in the informational efficiency of prices.

    Provides the most complete analysis of the ways markets aggregate informationBridges the gap between the rational expectations and herding literaturesIncludes exercises with solutionsServes both as a graduate textbook and a resource for researchers, including financial analysts

    eISBN: 978-1-4008-2950-7
    Subjects: Economics, Finance

Table of Contents

  1. Introduction and Lecture Guide
    (pp. 1-14)

    Information is at the heart of the economy today. Despite this there is still a lively debate over whether markets aggregate the dispersed information of agents in the economy or whether they are at the mercy of herd behavior and fads and in the hands of short-term speculators and insiders. The debate has old roots and goes back at least to the exchange between Hayek and Lange in the 1930s about the economic viability of socialism. While Lange (1936, 1937) argued that socialism was viable because a competitive allocation can be replicated by a central planner, Hayek contended that the...

  2. 1 Aggregation of Information in Simple Market Mechanisms: Large Markets
    (pp. 15-52)

    The aim of this chapter is to provide an introduction to the most basic models of information aggregation: static simple market mechanisms where traders do not observe any market statistic before making their decisions. Each agent moves only once, simultaneously with other agents, and can condition his action only on his private information. The issue is whether market outcomes replicate or are close to the situation where agents have symmetric information and share the information in the economy. Examples of such market mechanisms are one-shot auctions and quantity (Cournot) and price (Bertrand) competition markets. In chapters 3–5 we will...

  3. 2 Aggregation of Information in Simple Market Mechanisms: How Large Is Large?
    (pp. 53-77)

    This chapter continues the study of simple market mechanisms in the context of markets with a finite number of participants. In chapter 1 we assumed that market participants were so small that they could not influence prices. What if this is not true and strategic behavior is possible? How large does a market need to be for price-taking behavior to be a reasonable approximation? If a large market aggregates information, how fast does it happen? Which is the more important obstacle to efficiency: market power or lack of information aggregation? Do the answers to the questions depend on the type...

  4. 3 Rational Expectations and Supply Function Competition
    (pp. 78-106)

    In the first two chapters we examined whether simple market mechanisms would aggregate information. In those mechanisms each agent can condition his action only on his private information and, somewhat strikingly, in some cases such as auctions the market would aggregate information. In this chapter we will consider more complex market mechanisms where traders can also condition on a market statistic like the price. The concept of rational expectations equilibrium (REE) considers the role of prices as aggregators of information. Prices therefore serve a dual role as index of scarcity and conveyor of information. In other words, they clear the...

  5. 4 Rational Expectations and Market Microstructure in Financial Markets
    (pp. 107-155)

    In this chapter we review the basic static (or quasistatic) models of financial markets with asymmetric information in a competitive environment. Strategic traders are introduced in chapter 5. The dynamic trading counterpart of the models in chapters 4 and 5 is to be found in chapters 8 and 9. We study both rational expectations models, where traders have the opportunity to condition on prices as in chapter 3, and models where traders use less complex strategies and cannot condition on prices as in the simple market mechanisms of chapter 1. We also consider mixed markets where some traders use complex...

  6. 5 Strategic Traders in Financial Markets
    (pp. 156-198)

    In this chapter we review basic static models of financial markets with asymmetric information in the presence of strategic traders. We are interested in finding out the impact of large traders on the informational properties of prices and other main market quality parameters. We will do so in a variety of market microstructures where traders compete simultaneously in demand schedules, as well as those in which informed traders move first and those in which market makers move first. We will also look at the consequences of traders using market orders and of discriminatory pricing.

    Hellwig (1980) pointed at the “schizophrenia”...

  7. 6 Learning from Others and Herding
    (pp. 199-247)

    In the preceding chapters we have considered static models of market interaction in which agents would learn from prices and their private signals. This is not the only way for agents to learn about the parameters they are uncertain about. To start with, learning is a dynamic process. Furthermore, agents can also learn from other agents and, in particular, from the actions of other agents. Actions speak louder than words, the saying goes. Examples abound: consumers purchase the most popular brands, tourists patronize well-attended restaurants, and readers buy best-sellers. Learning from others can use informal routes like word-of-mouth. There has...

  8. 7 Dynamic Information Aggregation
    (pp. 248-275)

    In chapters 1–5 we considered static models. However, information revelation has important dynamic implications as we saw in chapter 6 when considering social learning. In chapter 6 we considered models of pure informational externalities. A first issue is whether the results obtained are robust when considering models with payoff externalities, as most market models. A second issue to explore is whether there is dynamic information aggregation when in a corresponding static market there would not be. We saw in chapter 1 that simple market mechanisms, like Cournot, need not aggregate information. However, repeated market interaction may make the economy...

  9. 8 Dynamic Rational Expectations Models in Competitive Financial Markets
    (pp. 276-329)

    In chapter 4 we studied in depth different versions of the static financial market model with asymmetric information. In chapters 6 and 7 we turned to dynamic issues by studying information revelation through time in the context of stylized prediction models (chapter 6) or of simple Cournot-type models (chapter 7). It is now time to use the tools developed in those dynamic models to study financial markets. In this chapter we will deal with competitive dynamics. The next chapter will introduce strategic traders.

    The chapter deals with dynamics of pricing and market quality parameters, such as price informativeness, market depth,...

  10. 9 Price and Information Dynamics in Financial Markets
    (pp. 330-368)

    This chapter considers dynamic markets where informed traders use market orders and introduces strategic behavior to analyze the consequences for the informational dynamics of the market and associated trading patterns. It provides the dynamic trading counterpart of the static models presented in section 4.3 and in chapter 5.

    Some of the questions addressed in the chapter are:

    Can herding arise in a sequential trading market?

    Is learning from past prices (technical analysis) fast or slow?

    What is the role of market makers in the price-discovery process?

    Will an insider trade slowly, so as to control the potential information leakage out...