We consider a market of a financial security where trading is based a quote-driven system, i.e., investors need to trade through market makers (MMs). Following the classical literature on asymmetric information, we assume that, at the initial time, an informed trader receives a noisy signal about the security’s payoff, whereas a mass of uniformed traders gets only a public one. On the other hand, risk averse MMs exploit their market power by quoting bid and ask prices based on the demand schedules submitted by all traders. In such setting, we introduce a novel strategic behavior for the informed trader, who submits demand schedule based, not only on her private signal, but also on the uniformed traders’ demands. We show that informed trader’s strategic behavior results in lower trading volume, but also lower bid-ask spread. The effect becomes more intense when informed trader’s risk tolerance and asymmetric information increase. Interestingly enough, an imperfect competition among two informed traders would reduce the bid-ask spread even further. This is a joint working paper with my PhD student Mr. Vasileios Nastoulis.
Strategic informed traders and risk averse market makers