DP9958 Man or machine? Rational trading without information about fundamentals

Author(s): Stefano Rossi, Katrin Tinn
Publication Date: May 2014
Keyword(s): Kyle model, log-concavity, rational expectations, rational price-contingent trading
JEL(s): D82, G12, G14
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9958

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.