Information spillover in markets with heterogeneous traders

Abstract

This paper studies the welfare impact of information spillover in divisible good markets with heterogeneous traders and interdependent values. In a setting where two groups of traders trade two distinct but correlated assets, one within each group, the information contained in the price of one asset spills over to the other market. Some “more informed” traders who submit demand schedules may condition their demands on the prices of both assets, while others do not. We prove the existence of a linear equilibrium and examine how information spillover affects trading, information efficiency, and welfare, as the fraction of the more informed traders varies. In the two symmetric benchmarks, full information spillover (all traders are more informed) dominates no information spillover (all traders are less informed) in terms of welfare. However, in markets with heterogeneous traders, information spillover can hurt overall welfare, while still improving information efficiency; we characterize the non-monotonic impact of information spillover on aggregate welfare in large finite markets. Furthermore, information spillover can account for the empirical evidence of excessive price co-movement and volatility transmission in financial markets.