Stock Price Manipulation, Market Microstructure and Asymmetric Information (Reprint 024)

Franklin Allen and Gary Gorton

Rodney L. White Center for Financial Research Working Papers from Wharton School Rodney L. White Center for Financial Research

Abstract: In recent years, there has been a large literature on how stock exchange specialists set prices when there are investors who know more about the stock than they do. An important assumption in this literature is that there are "liquidity traders" who are equally likely to buy or sell for exogenous reasons. It is plausible that some buyers have cash needs and are forced to sell their stock. However, buyers will usually be able to choose the time at which they trade. It will be optimal for them to minimize the probability of trading with informed investors by choosing an appropriate time to trade and clustering at that time. This asymmetry means that when liquidity buyers are not clustering, purchases are more likely to be by an informed trader than sales so the price movement resulting from a purchase is larger than for a sale. As a result, profitable manipulation by uninformed investors may occur. A model where the specialist takes account of the possibility of manipulation in equilibrium is presented.

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