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Price Continuity Rules and Insider Trading

Published online by Cambridge University Press:  06 April 2009

Prajit K. Dutta  and
Ananth Madhavan
Prajit K. Dutta
Affiliation:
Department of Economics, Columbia University, New York, NY 10025
Ananth Madhavan
Affiliation:
School of Business Administration, University of Southern California, Los Angeles, CA 90089
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Abstract

Restrictions on transaction price changes are a feature of many security markets. This paper analyzes the impact of such price continuity rules on price dynamics and examines possible rationales for their existence. Contrary to popular belief, continuity rules need not reduce price efficiency, although they do result in a redistribution of profits among traders and dealers. Indeed, continuity rules may enhance price efficiency because traders have greater incentives to gather costly information. We provide a new rationale for continuity rules besides the stated objective of stabilizing prices. In particular, we show that continuity requirements act to restrict dealers' expected profits from trading with liquidity traders. The results provide insights into the design of an “optimal” continuity rule.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 30 , Issue 2 , June 1995 , pp. 199 - 221
Copyright
Copyright © School of Business Administration, University of Washington 1995

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