Informed Traders

TL;DR

This paper models an informed trader with access to extra noisy information, demonstrating how such information can be exploited for statistical arbitrage and quantifying its value through mutual information measures.

Contribution

It introduces a novel asymmetric information model with correlated noise, providing explicit trading strategies for arbitrage based on additional information.

Findings

Informed trader can achieve statistical arbitrage using extra noisy information.

The value of additional information is quantified by mutual information differences.

Explicit strategies demonstrate profit opportunities from excess information.

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.