Information-Based Trading

TL;DR

This paper analyzes a market model with two traders having different information levels, demonstrating that the more informed trader always has a strictly greater position value, supported by simulations and extended to complex trading scenarios.

Contribution

It introduces a model of asymmetric information trading with a strict valuation advantage for the more informed trader, extending to hierarchical and multi-trade contexts.

Findings

More informed trader's position value exceeds that of less informed.

Simulation results support theoretical valuation differences.

Extensions include multiple trades, hierarchies, and inventory considerations.

Abstract

We consider a pair of traders in a market where the information available to the second trader is a strict subset of the information available to the first trader. The traders make prices based on the information available concerning a security that pays a random cash flow at a fixed time $T$ in the future. Market information is modelled in line with the scheme of Brody, Hughston & Macrina (2007, 2008) and Brody, Davis, Friedman & Hughston (2009). The risk-neutral distribution of the cash flow is known to the traders, who make prices with a fixed multiplicative bid-offer spread and report their prices to a game master who declares that a trade has been made when the bid price of one of the traders crosses the offer price of the other. We prove that the value of the first trader's position is strictly greater than that of the second. The results are analyzed by use of simulation studies and generalized to situations where (a) there is a hierarchy of traders, (b) there are multiple successive trades, and (c) there is inventory aversion.