Trading Costs and Informational Efficiency
66 Pages Posted: 22 Oct 2016 Last revised: 23 Jan 2017
Date Written: August 1, 2016
Abstract
We study the effect of trading costs on information aggregation and information acquisition in financial markets. For a given precision of investors’ private information, an irrelevance result emerges when investors are ex-ante identical: price informativeness does not depend on the level of trading costs. This result holds independently of whether trading costs are quadratic or linear, investors behave competitively or strategically, and applies to both static and dynamic economies. When investors are ex-ante heterogeneous, trading costs reduce (increase) price informativeness if and only if investors who disproportionately trade on information are more (less) elastic than investors who mostly trade due to hedging. Trading costs always reduce information acquisition and consequently price informativeness, even when price informativeness remains unchanged for a given amount of information. Our results matter to understand the consequences of cheaper financial trading and the effects of financial transaction taxes.
Keywords: learning, trading costs, information aggregation, information acquisition, financial transaction taxes
JEL Classification: D82, D83, G14
Suggested Citation: Suggested Citation