Chapter 10 Informed Traders and Market Efficiency

1. Chapter 10 Informed Traders and Market Efficiency

2. Informed traders • Acquire and act on information about fundamental values. • Buy (sell) when prices are below their estimates of fundamental value. • Include value traders, news traders, information-oriented technical traders, and arbitragers.

3. Fundamental values • The true values • Not perfect foresight values • Prices are said to informative when they are equal to fundamental values • Fundamental values are not predictable (why?) • Price changes in efficient markets are not predictable (why?)

4. Informed traders make prices informative • Because they buy (sell) when price is below (above) their estimates of fundamental value, their trading move prices toward their estimates of fundamental value. • When informed traders accurately estimate values, their trading makes prices more informative.

5. The market price is more informative than individual value estimates V = the true fundamental value, P = the market price, fi = the forecast of trader i; fi = V + ei, where E(ei) = 0, Di = trader i’s desired position in the security; Di = a(fi – P), where a is a constant. From ∑ Di = ∑ a(fi – P) = 0 (i.e., zero net supply), we have P = (1/N) ∑fi = (1/N) ∑(V + ei) = V + eM, where eM = (1/N) ∑ei ≈ 0.

6. Informed trading strategies • Must minimize price impact to maximize profits. • Trade aggressively when their private information will soon become common knowledge. • Trade slowly when their private information will not soon become common knowledge. • Trade aggressively when other traders will act on the same information.

7. Styles of informed trading • Value traders – all information • News traders – new information • Information-oriented technical traders – predictable price patterns • Arbitragers – relative instrument values rather than absolute instrument values

8. Informed trading profits • Precise and orthogonal estimates • Informed trading can be profitable only when informed traders trade with uninformed traders • Uninformed traders tolerate losses because they obtain other valuable services from the market. • Informed trading is not profitable in markets where traders can easily identify informed traders. These markets may have less informative prices.

9. Market paradox • Impossibility of informationally efficient markets (Grossman and Stiglitz) • Informed traders make prices informative, but prices are not always informative • Prices move away from fundamental values when values change and prices do not change accordingly – This happens when news arrives – News traders make profits. • Prices move away from fundamental values when prices change without a change in values – This happens when trading by uninformed traders moves prices – Value traders make profits.

10. Efficient markets hypothesis • Prices never fully reflect all information that informed traders could collect and act on. • Weak form efficient markets • Semi-strong form efficient markets • Strong-form efficient markets.

11. Liquidity and Predictability-Strategic Trading with Private Information and Price Impact • If you buy a contract, you receive $1 with a probability of π and zero with 1- π. • The market price of the contract is P = 0.3 + ¼(Q/L), where Q is your trade size and L denotes liquidity. Your profit = πQ – PQ = πQ – [0.3 + ¼(Q/L)]Q Your profit is maximized when Q = 2L(π – 0.3) Your maximum profit = L(π – 0.3)2

12. Liquidity vs. Informative Prices • Uninformed traders pay for the information that goes into prices. This lowers their net benefits from using the markets. • Curbing informed trading raises liquidity, but makes prices less informative. • Benefits of informative prices may greatly outweigh uninformed traders’ loss to informed traders.

13. Trading halts for impending information • Many markets require that their listed firms contact them before the release of material information to the public. • They halt trading until after the information release. • Trading halts protect uninformed traders, but make prices less informative • The protection of uninformed traders is more important than the lost price efficiency. Why?

14. Benefits of Public Information • Public disclosure of material information increases both liquidity and informational efficiency of prices. • Publishing information allows traders to know values better. Informed traders do not profit as much as they would if they could trade at a slower rate. • Many stock markets require a timely information disclosure for listed firms. • Firms voluntarily provide information to make their stocks more attractive • Government agencies produce statistical information about the economy. • Private (e.g., Bloomberg, IBES) companies sell information

15. Regulation Fair Disclosure • The Securities and Exchange Commission's Regulation Fair Disclosure, also commonly referred to as Regulation FD or Reg FD was an SEC ruling implemented in October 2000. It mandated that all publicly traded companies must disclose material information to all investors at the same time. • The regulation sought to stamp out selective disclosure, in which some investors (often large institutional investors) received market moving information before others (often smaller, individual investors). • Regulation FD changed fundamentally how companies communicate with investors, by bringing better transparency and more frequent and timely communications, perhaps more than any other regulation in the history of the SEC.

16. SEC Rules 11Ac1-5 and -6 • Public disclosure of order execution quality http://papers.ssrn.com/sol3/papers.cfm?abstract_id=878351 • Public disclosure of order routing practice