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Informed traders

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Title: Informed traders
Authors: Brody, DC
Davis, MHA
Friedman, RL
Hughston, LP
Item Type: Journal Article
Abstract: An asymmetric information model is introduced for the situation in which there is a small agent who is more susceptible to the flow of information in the market than the general market participant, and who tries to implement strategies based on the additional information. In this model market participants have access to a stream of noisy information concerning the future return of an asset, whereas the informed trader has access to a further information source which is obscured by an additional noise that may be correlated with the market noise. The informed trader uses the extraneous information source to seek statistical arbitrage opportunities, while at the same time accommodating the additional risk. The amount of information available to the general market participant concerning the asset return is measured by the mutual information of the asset price and the associated cash flow. The worth of the additional information source is then measured in terms of the difference of mutual information between the general market participant and the informed trader. This difference is shown to be nonnegative when the signal-to-noise ratio of the information flow is known in advance. Explicit trading strategies leading to statistical arbitrage opportunities, taking advantage of the additional information, are constructed, illustrating how excess information can be translated into profit.
Issue Date: 8-Apr-2009
Date of Acceptance: 17-Nov-2008
URI: http://hdl.handle.net/10044/1/64374
DOI: https://dx.doi.org/10.1098/rspa.2008.0465
ISSN: 1364-5021
Publisher: Royal Society, The
Start Page: 1103
End Page: 1122
Journal / Book Title: Proceedings of the Royal Society A: Mathematical, Physical and Engineering Sciences
Volume: 465
Issue: 2104
Copyright Statement: © 2008 The Royal Society.
Keywords: Science & Technology
Multidisciplinary Sciences
Science & Technology - Other Topics
statistical arbitrage
asymmetric information
information-based asset pricing
hedge funds
insider trading
mutual information
01 Mathematical Sciences
02 Physical Sciences
09 Engineering
Publication Status: Published
Online Publication Date: 2009-03-05
Appears in Collections:Financial Mathematics
Faculty of Natural Sciences