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.