Informational leverage: the problem of noise traders

The literature suggests that security design can be used to manipulate the information content of securities prices [what is referred to as the "informational leverage effect" in Boot and Thakor (J Finance 48, 1349-1378, 1993)]. The informational leverage effect arises in this literature in a market microstructure environment in which noise trade is exogenous, which is a fairly standard assumption dating back to t he framework developed in Grossman and Stiglitz (Am Econ Rev 70, 393-408, 1980). This assumption is relaxed in our paper, and we show that the informational effects described in the related literature become less clear cut when noise trading activity is endogenous. We find that the intensity and direction of these effects depends crucially on the parameters describing the modeling environment. The elegant point of the informational leverage literature is that these effects arise largely independently of such parameters, but with endogenous noise tr ading that is no longer true. This literature may, therefore, lead to too strong conclusions being drawn about the relationship between information revelation and security design. © Springer-Verlag 2007.