The basic premise of the model we propose is that market frictions (trading costs) force traders with market-wide information to strategically choose which securities to trade in. We study the effect of recognizing trading costs on the choices of informed traders and the resulting statistical properties of security prices. Specifically, we show that (1) stocks with intermediate β's have the least informative prices, even though they are traded by the greatest number of informed traders; (2) for high β securities, the contemporaneous correlation of prices is close to the correlation in fundamental values; (3) a security with a higher β, higher volume of liquidity trading and lower idiosyncratic variance is more likely to lead another security. With market capitalization as a proxy for the level of liquidity trading, these specific predictions of the model on the lead-lag relationship are also shown to be strongly supported by the data.
Bibliographical noteFunding Information:
We are especially indebted to Avanidhar Subrahmanyam (editor) and an anonymous referee for providing direction and invaluable insights. We also acknowledge the helpful comments of Sugato Bhattacharyya, Bruno Biais, Peter Bossaerts, David Brown, K.C. Chan, Rick Green, Larry Harris, Arnold Juster, Duane Seppi, Chester Spatt, Sheridan Titman and seminar participants at Carnegie Mellon University, Seoul National University, the Hong Kong University of Science and Technology, 1996 European Finance Association Conference at Oslo, 1997 Australian Finance and Banking Conference. We are grateful for the financial support from the William Larimer Mellon Fund and the Margaret and Richard M. Cyert Family Fund. The usual disclaimer applies.
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- Lead-lag effect
- Market microstructure
- Trading costs