Information spillover in markets with heterogeneous traders; Heng Liu (University of Michigan)

Abstract

This paper studies the welfare impact of information spillover in divisible-good markets with heterogeneous traders and interdependent values. In a setting in which two groups of traders trade two distinct but correlated assets, one within each group, the information content in the price of one asset spillovers to the other market. Some "informed" traders who submit demand schedules may condition their demands on the prices of both assets, while others not. We prove the existence of a linear equilibrium and examine how information spillover affects trading, information efficiency, and welfare, as the fraction of informed traders varies. We find that full information spillover (all traders are informed) dominates no information spillover (all traders are uninformed) in terms of trading volume and welfare. However, in a market with heterogeneous traders, information spillover can hurt overall welfare, while still improving information efficiency and liquidity. Furthermore, information spillover can account for the empirical evidence of excessive price co-movements and volatility transmissions in financial markets.