DP9958 | Man or machine? Rational trading without information about fundamentals

Publication Date

04/05/2014

JEL Code(s)

Keyword(s)

Programme Area(s)

Network(s)

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.