Strategic Trading with Market Closures

Abstract

This paper analyzes the equilibrium trading strategies of informed traders in the presence of market closures defined as periodic predictable stops of trading. We construct a dynamic auction model based on rational strategic behavior with asymmetric information across the agents. Empirical evidence indicates that market closures have important impact on the information structure of financial markets, in particular the private information flow. In our model, the insiders repeatedly increase their informational advantage over other agents by receiving private signals about fundamentals when the market is closed. In a continuous-time setting, we solve a dynamic programming problem and derive closed-form solutions for optimal intertemporal strategies of both insiders and the market maker. The key feature of insiders' optimal strategy is that they act strategically by anticipating future market closures. Because of this, even though market closures are periodic, the intertemporal pattern of optimal trading strategies is {not} periodic. This aperiodicity of trading is quite important since while it is a definitive feature of the data, it has been missing from the existing theoretical literature on market closures. In agreement with broad empirical evidence, we obtain a U-shaped pattern of trading volume during the periods when the market is open, superimposed on a U-shaped pattern during the lifetime of the economy, before all information about the asset is revealed.