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Chapter 10

Liquidity, Price Discovery and


Corporate Policies

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10.7 Exercises

2. Stock market as guide to investment. In the model analyzed in section


10.4.1, we assumed that G < I and found that on average the stock market encour-
ages investment. Consider here the complementary case where G > I:

a. Show that in this case the stock market deters inappropriate investment.
Explain the intuition behind this result.
b. Assume that the market is informative enough for the stock price to aect
investment and derive the new expression for the increase in firms ex-ante value
resulting from the presence of a stock market.

4. Bid and ask prices when investment does not react to stock prices.
In the model analyzed in section 10.4.1, assume that the informativeness condition
(10.5) does not hold.

a. Compute the equilibrium bid and ask prices, and show that in this case too,
in equilibrium the informed speculator will buy upon receiving positive information
and sell otherwise.
b. Compute the bid-ask spread and find out whether in this case it is increasing
in the frequency of informed trading .
c. Compare this bid-ask spread with that given by equation (10.12) under the
informativeness condition (10.5).
d. Finally, compute the midprice and see whether it depends on the frequency
of informed trading , explaining why.

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10.8 Solutions

Exercise 2:
a. If G > I the projects expected net present value, 12 G 12 I, is positive, so
that the manager has incentive to invest even when he has no information about the
quality of the project.
It follows that, in the absence of a stock market, the manager does not invest
only if he receives private information and if the information is negative. Viceversa,
in the presence of a stock market, depending on whether the manager observes a
transaction at the ask or at bid, he updates his estimate of the probability of the
project being of quality H or L, exactly as in Section 10.4.1:

1+
Pr(H |p = a) = Pr(L |p = b ) = ,
2
1
Pr(H |p = b ) = Pr(L |p = a) = .
2

Since the unconditional expected net present value of the project is positive, a
fortiori the expected net present value conditional on observing a buy order is positive
for every possible value of . In fact:

1+ 1 I G
G I>0 if
2 2 I +G
IG
and is always greater than I+G
given that G > I.

I G
.
I +G

On the contrary, when the manager observes a sell order, the expected net present
value of the project conditional on observing a sell order becomes:

1 1+
G I
2 2

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which is negative if and only if
GI
.
I +G
So, when stock market trading is informative enough, it deters inappropriate
investment as we wanted to show.
b. As we have done in Section 10.4.1, we compare the outcome of the investment
decision with and without a stock market to compute the allocative value of the in-
formation coming from the stock market. Again we assume that the informativeness
condition we have derived under point a) holds otherwise the stock market would
clearly play no role in the investment decision.
In the absence of a stock market, the manager will invest both when he receives
private information about the project and if the information is positive, which hap-
pens with probability 2 , and when he receives no information, given that the ex-ante
expected net present value of the project is positive. Therefore, the ex ante value of
the firm, if privately held, is

GI
Vprivate = V + G + (1 )
2 2 }
| {z
NPV

On the other hand, if the firm is listed on the stock market, the manager does
not invest iin case he observes a transaction at the bid price, provided that the
informativeness condition holds. As before, he receives positive private information
with probability /2, in which case again he invests. If he does not receive private
information, which occurs with probability 1 , he invests only when he observes
a buy order which occurs with probability 1/2. Therefore, the ex ante value of the
firm when publicly listed is
% &
1 1+ 1
Vpublic =V + G+ G I
2 2 2 2

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which is the same we have derived in Section 10.4.1.
The dierence between Vpublic and Vprivate represents the increase in firms ex-ante
value which comes from the presence of the stock market:
! " # $
1 1+ 1 GI
Vpublic Vprivate = V + G + G I V + G + (1 ) =
2 2 2 2 2 2
# $
1 G+I GI
= .
2 2 2

Moreover, we can also notice that the total contribution of the stock market to
the investment decision is composed of two eects: the gain from not investing when
investment is inappropriate and the loss from underinvesting when noise trader sells
stock. As we can easily see, the net eect is positive whenever the informativeness
condition holds. In fact:

G+I GI GI
0, .
2 2 I +G

Exercise 4: The equilibrium ask price is:


a = V + (1 ) G + G
2

and the equilibrium bid price is:


b = V + (1 ) G,
2

so that the bid-ask spread is


S = G,

which is increasing in . Since now we are assuming that condition (10.5) does not
hold, this bid-ask spread will be smaller than [(I G)/(I + G)] G. In contrast,
under the informativeness condition (10.5), the spread given by equation (10.12)

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exceeds [(I G)/(I + G)] G. Hence, when is low enough that stock prices are
disregarded as a guide for investment, the market is more liquid than when is large
enough that they are used to guide investment.
The mid price is
G
m=V + ,
2
so that it doe not depend on , because in this case informed trading does not
contribute to the allocation of investment and therefore does not aect the firms
value.