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Predatory Trading

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Predatory Trading

This paper by Markus Brunnermeier and Lasse Pedersen, studies the effect of predatory trading on asset pricing and liquidity. Predatory trading occurs when some traders trade in anticipation or in conjunction with the forced liquidation of a large investor. The predators trade strategically to maximize their profits and aim to destabilize the large investor: they initially trade in the same direction as the liquidating investor, reducing liquidity and causing prices to overshoot. Predatory trading is more important when there are fewer traders.


In their model, there are large strategic traders and long-term investors who are price takers. The strategic traders can either be distressed or unaffected. They have limited capital, cannot trade instantly and move prices when they trade. In equilibrium, the traders choose their trading strategies taking into account the strategies of the other traders.
In equilibrium, the strategic traders sell as long as the distressed traders sell and cause the liquidated asset price to overshoot. Towards the end of the liquidation, the strategic traders repurchase the asset at a distressed price. This behavior hurts the liquidating trader because liquidity is withdrawn and trading prices are worse because of the overcrowding.
With more traders, the overshooting is smaller because of more competition an less gain from strategic behavior.
If there is more sidelined capacity, the undistressed traders buy back share immediately because competition increases their incentives to own the shares before the others and benefit from the recovery  in value.
The authors also examine endogenous distress and how it can be caused by predatory trading. They assume that traders have limited wealth and need to maintain a minimum level to survive. They find that the presence of more distressed lessens the probability of surviving because prices decline and predatory trading is more aggressive. This creates systematic risk and can destabilize markets since more distressed traders can affect other traders by reducing their wealth and put them in distress. The crash of 1987 seems to be case in point with the portfolio insurance strategies.
This has also consequences for risk management. A rigid risk management system facilitates the work of predators since they can anticipate forced liquidation of risk management constrained traders. Disclosure of trading positions also help the predators since they can determine the wealth level of potentially distressed investors. Full public disclosure might however alleviate predation since competition increases and long-term investors might invest in the distressed assets.
The authors also examine the effect of front running, market practices that can limit the problem of predatory trading , bear raids and the up-tick rules and a new explanation for financial contagion.

The paper can be found at:

Brunnermeier, Markus K. and Pedersen, Lasse Heje, "Predatory Trading" (September 2004). CEPR Discussion Paper No. 4639. Available at SSRN: http://ssrn.com/abstract=622064

Or in the Journal of Finance, VOL. LX, NO. 4, August 2005

http://pages.stern.nyu.edu/~lpederse/papers/predatory_trading.pdf

see also {ln:Liquidity Risk and Expected Stock Returns}

 

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