An Index-Contingent Trading Mechanism: Economic Implications

Abstract

In many stock exchanges around the world "batch" or "clearing" is used as a method of trading. Currently, an essential problem in the application of this trading mechanism is that orders in one security cannot be conditioned on prices of other securities. In this paper we propose to move one step in the direction of cross-conditioning and to facilitate conditioning on an index (a weighted average of the stock prices) that is simultaneously determined with the prices of all assets. The economic implications of this trading mechanism are analyzed in the framework of rational expectations equilibrium models and certain empirical implications are derived. We show that an index-contingent trading mechanism may contribute to the efficiency of prices and to the reduction of losses and risks sustained by noise traders. In particular, we compare two trading systems, with and without index-conditioning, and find that in the system with index-conditioning (i) price fluctuations around "true" values are lower, (ii) expected losses of "noise traders" are lower, (iii) the variance of the payoffs to the "noise traders" is lower,(iv) the expected utility of informed traders is lower, and (v) the expected volume of trade is higher than in a model without cross-conditioning.

JEL Classification: G12