Chapter 10
Informed Traders and
Market Efficiency
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.

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?)

Informed traders make prices
informative

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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.
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.
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.

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

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.

Market paradox
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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.
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.

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
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.

Trading halts for impending
information

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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?
Benefits of Public Information
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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
Regulation Fair Disclosure

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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.
SEC Rules 11Ac1-5 and -6

Public disclosure of order execution quality
http://papers.ssrn.com/sol3/papers.cfm?ab
stract_id=878351

Public disclosure of order routing practice