When Are Financial Markets Perfectly Competitive?

Abstract

We study competitiveness of financial markets in a one-period model, in which traders speculate on private information and hedge endowment shocks. Developing and fully characterizing a new measure of market competitiveness, we find that market becomes perfectly competitive if and only if the number of traders approaches infinity and speculation becomes negligible relative to hedging. While perfect competition – the key assumption for rational expectations equilibrium – is a strong condition, we show when it can be made innocuous and when it cannot. We discuss further implications of market competitiveness for the measurement of liquidity and the real-world financial market design.

Keywords: market competitiveness, strategic trading, price-taking, rational expectations equilibrium, private information, liquidity, market design.