Chapter 8

Market Transparency

1
8.6 Exercises

2. Price discovery and transparency. Consider the model of post-trade trans-

parency described in section 8.2. Consider the time-averaged expected squared de-
viation between the transaction price and the true value of the security, that is

! " ! "
E (pk1 v)2 E (pk2 v)2
+ ,
2 2
where pkt is the transaction price in period t = 1, 2 in regime k = T, O (transparent,
opaque). Show that price discovery is more ecient in the transparent market. You
1
may limit your analysis to the case > 2
in which the equilibrium first-period spread
is positive.

8.7 Solutions

Exercise 2: Consider first the post-trade transparent regime. In the first trading
period, the deviation between true value and transaction price will be as in the
opaque regime of section 8.1.3, that is,

! " ! " # $# $2
E (pT1 v)2 = E (pO
1 v)
2
= 1 2 vH

The second-period price is equal to the true value if an informed trader is present
and equal to if there is an uninformed trader (maintaining the assumption that
such as trader always reverses his earlier transaction):

! " # $2 # $2
E (pT2 v)2 = 0 + (1 ) v H = (1 ) v H

2
 Averaging over the first and second trading rounds,
! " ! " #
E (pT1 v)2 E (pT2 v)2 $ H
+ = (1 ) 1 + (v )2
2 2 2
1
In the opaque regime,assuming > 2
so that the are no potentially crossed quotes
in the first period, the first period quotes are, by equation (8.10) :

% H &
aO
1 = + (2 1) v
% &
bO
1 = (2 1) v H

and so:

! " % &2
E (pO
1 v)
2
= (1 (2 1)) v H
1 % &2 1 % &2
+ (1 (2 1)) v H + (1 + (2 1)) v H
2 2
% &2
= (1 ) (1 + 2) v H

In the second period, the quotes are v H and v L and thus the price is equal to the
true value for an informed trade and for half the uninformed trades, while it is the
% &
maximum distance v H v L away for the other half of the uninformed trades:
' (
! O 2
" 1 1 % H &2 % &2
E (p2 v) = + 0+ v v L = 2 (1 ) v H
2 2

So clearly post-trade opaqueness makes the second-period price less accurately reflect
fundamentals.

! " ! "
E (pO
1 v)
2
E (pO
2 v)
2
+ = (1 ) (1.5 + ) (v H )2
2 2