Cladistic Asset Pricing

University Of Illinois At Urbana-Champaign, Urbana IL

Investigators

Abstract

Understanding how asset prices respond to strategic interplay among differentially informed agents is an important requirement for efficient regulation security markets, yet this phenomenon is not well understood and modeled. The proposed research will explore the behavior of stock markets when there are speculative traders who possess information that is not available to the market as a whole. In such an environment, one wishes to determine how the strategic interplay between differentially-informed agents affects market prices, volume and profits over time. In many of the contexts in which speculative traders have private information about a firm's value, they will continue to have access to new, long-lived information over the time on a recurring basis. For example, corporate insiders will not only have information about current and past earnings; they likely will be privy to new information about earnings. Investors, too, often focus on a small number of stocks or narrow sectors on which to do research. Their accumulated expertise leaves them better situated to evaluate the information both immediately after they learn it, and when it arrives in the future. The profession has not developed a methodology that can analyze equilibrium outcomes when multiple agents have recurring access to private information; much less characterize outcomes in such environments. The proposed research will develop new methods that can tractably encompass both current and past information. The main innovation in the model is to assume that the information received by each individual as an AR(1) process, thus allowing for an equilibrium solution. This results then makes it possible to answer several questions, such as: How do informed agents use current and past signals, and the information in current and past prices, to determine how much to trade at each date? What are the consequences for equilibrium price dynamics? The scope of the methods makes it possible to explore the central issues in the theory of asset markets such as: the effect of competition among informed agents on strategic trading and equilibrium price dynamics; whether and when increased competition leads to more information being revealed through price, and how this is related to the 'age' of the information; how the structure of the information affects the strategic trading behavior, pricing and information revelation; characteristics of market when some traders are better informed than others; the effects of information about one asset on the prices and dynamics of order flows of other assets; and the effects of collusion on price and order flows, and ways to detect such collusion empirically. The methodology is tractable enough to be broadly used to study equity trading models, as well as the analyses of a broad range of economic models in which information is embodied in prices.