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Title: Man or machine? Rational trading without information about fundamentals

Author(s): Stefano Rossi and Katrin Tinn

Publication Date: May 2014

Keyword(s): Kyle model, log-concavity, rational expectations and rational price-contingent trading

Programme Area(s): Financial Economics

Abstract: We present a model of quantitative trading as an automated system under human supervision. Contrary to previous literature we show that price-contingent trading is the profitable equilibrium strategy of large rational agents in efficient markets. The key ingredient is uncertainty about whether a large trader is informed about fundamentals. Even when uninformed, he still learns more from prices than market participants who still wonder about whether he is informed. Therefore, he will trade a non-zero quantity based on past prices, whose direction ? trend-following or contrarian ? depends on parameters. When informed, he will trade on that information and disregard the algorithm. One implication is that future order flow is predictable even if markets are semi-strong efficient by construction.

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Bibliographic Reference

Rossi, S and Tinn, K. 2014. 'Man or machine? Rational trading without information about fundamentals'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9958