IDEAS home Printed from https://ideas.repec.org/a/eee/jetheo/v199y2022ics0022053121000181.html
   My bibliography  Save this article

Robust pricing under strategic trading

Author

Listed:
  • Gong, Aibo
  • Ke, Shaowei
  • Qiu, Yawen
  • Shen, Rui

Abstract

We study strategic trading with a market maker who does not know the joint distribution of public information and an asset's value, and hence cannot interpret information properly. Following a public event, a probabilistically informed trader who knows the distribution and liquidity traders trade. The market maker adopts a robust linear pricing strategy that has the best worst-case payoff guarantee. We show that such a strategy is equivalent to a two-step learning procedure, and characterize the unique linear equilibrium. Expected equilibrium prices exhibit underreaction to public information. If the trading frequency is arbitrarily high, the market maker fully reveals the distribution in the price eventually.

Suggested Citation

  • Gong, Aibo & Ke, Shaowei & Qiu, Yawen & Shen, Rui, 2022. "Robust pricing under strategic trading," Journal of Economic Theory, Elsevier, vol. 199(C).
  • Handle: RePEc:eee:jetheo:v:199:y:2022:i:c:s0022053121000181
    DOI: 10.1016/j.jet.2021.105201
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0022053121000181
    Download Restriction: Full text for ScienceDirect subscribers only

    File URL: https://libkey.io/10.1016/j.jet.2021.105201?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Lars Peter Hansen & Thomas J Sargent, 2014. "Beliefs, Doubts and Learning: Valuing Macroeconomic Risk," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 10, pages 331-377, World Scientific Publishing Co. Pte. Ltd..
    2. Harrison Hong & Terence Lim & Jeremy C. Stein, 2000. "Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies," Journal of Finance, American Finance Association, vol. 55(1), pages 265-295, February.
    3. Liyan Yang & Haoxiang Zhu, 2020. "Back-Running: Seeking and Hiding Fundamental Information in Order Flows," Review of Finance, European Finance Association, vol. 33(4), pages 1484-1533.
    4. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    5. Duffie, Darrell & Dworczak, Piotr, 2021. "Robust benchmark design," Journal of Financial Economics, Elsevier, vol. 142(2), pages 775-802.
    6. Lars Peter Hansen & Thomas J Sargent, 2014. "Robust Control and Model Uncertainty," World Scientific Book Chapters, in: UNCERTAINTY WITHIN ECONOMIC MODELS, chapter 5, pages 145-154, World Scientific Publishing Co. Pte. Ltd..
    7. Jianjun Miao & Alejandro Rivera, 2016. "Robust Contracts in Continuous Time," Econometrica, Econometric Society, vol. 84, pages 1405-1440, July.
    8. Bernard, Victor L. & Thomas, Jacob K., 1990. "Evidence that stock prices do not fully reflect the implications of current earnings for future earnings," Journal of Accounting and Economics, Elsevier, vol. 13(4), pages 305-340, December.
    9. Zengjing Chen & Larry Epstein, 2002. "Ambiguity, Risk, and Asset Returns in Continuous Time," Econometrica, Econometric Society, vol. 70(4), pages 1403-1443, July.
    10. Ikenberry, David & Lakonishok, Josef & Vermaelen, Theo, 1995. "Market underreaction to open market share repurchases," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 181-208.
    11. Beaver, Wh, 1968. "Information Content Of Annual Earnings Announcements," Journal of Accounting Research, Wiley Blackwell, vol. 6, pages 67-92.
    12. Larry G. Epstein & Martin Schneider, 2008. "Ambiguity, Information Quality, and Asset Pricing," Journal of Finance, American Finance Association, vol. 63(1), pages 197-228, February.
    13. Scott Condie & Jayant V. Ganguli, 2011. "Ambiguity and Rational Expectations Equilibria," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 78(3), pages 821-845.
    14. Bernard, Vl & Thomas, Jk, 1989. "Post-Earnings-Announcement Drift - Delayed Price Response Or Risk Premium," Journal of Accounting Research, Wiley Blackwell, vol. 27, pages 1-36.
    15. Benigno, Pierpaolo & Paciello, Luigi, 2014. "Monetary policy, doubts and asset prices," Journal of Monetary Economics, Elsevier, vol. 64(C), pages 85-98.
    16. Blankespoor, Elizabeth & deHaan, Ed & Marinovic, Iván, 2020. "Disclosure processing costs, investors’ information choice, and equity market outcomes: A review," Journal of Accounting and Economics, Elsevier, vol. 70(2).
    17. Shokofeh Zinodiny & Sadegh Rezaei & Saralees Nadarajah, 2017. "Minimax Estimation of the Mean Matrix of the Matrix Variate Normal Distribution under the Divergence Loss Function," Statistica, Department of Statistics, University of Bologna, vol. 77(4), pages 369-384.
    18. , G., 2013. "Managing pessimistic expectations and fiscal policy," Theoretical Economics, Econometric Society, vol. 8(1), January.
    19. Lars Peter Hansen, 2007. "Beliefs, Doubts and Learning: Valuing Economic Risk," NBER Working Papers 12948, National Bureau of Economic Research, Inc.
    20. Holden, Craig W & Subrahmanyam, Avanidhar, 1992. "Long-Lived Private Information and Imperfect Competition," Journal of Finance, American Finance Association, vol. 47(1), pages 247-270, March.
    21. David Easley & Maureen O'Hara, 2009. "Ambiguity and Nonparticipation: The Role of Regulation," The Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1817-1843, May.
    22. Epstein, Larry G. & Schneider, Martin, 2003. "Recursive multiple-priors," Journal of Economic Theory, Elsevier, vol. 113(1), pages 1-31, November.
    23. Andrea Frazzini, 2006. "The Disposition Effect and Underreaction to News," Journal of Finance, American Finance Association, vol. 61(4), pages 2017-2046, August.
    24. Gabriel Carroll, 2017. "Robustness and Separation in Multidimensional Screening," Econometrica, Econometric Society, vol. 85, pages 453-488, March.
    25. Keisuke Hirano & Jack R. Porter, 2003. "Asymptotic Efficiency in Parametric Structural Models with Parameter-Dependent Support," Econometrica, Econometric Society, vol. 71(5), pages 1307-1338, September.
    26. Kent Daniel & David Hirshleifer & Avanidhar Subrahmanyam, 1998. "Investor Psychology and Security Market Under- and Overreactions," Journal of Finance, American Finance Association, vol. 53(6), pages 1839-1885, December.
    27. Alfredo di Tillio & Nenad Kos & Matthias Messner, 2017. "The Design of Ambiguous Mechanisms," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 84(1), pages 237-276.
    28. Huddart, Steven & Hughes, John S & Levine, Carolyn B, 2001. "Public Disclosure and Dissimulation of Insider Trades," Econometrica, Econometric Society, vol. 69(3), pages 665-681, May.
    29. David Easley & Maureen O'Hara, 2010. "Microstructure and Ambiguity," Journal of Finance, American Finance Association, vol. 65(5), pages 1817-1846, October.
    30. Zinodiny, S. & Rezaei, S. & Nadarajah, S., 2017. "Bayes minimax estimation of the mean matrix of matrix-variate normal distribution under balanced loss function," Statistics & Probability Letters, Elsevier, vol. 125(C), pages 110-120.
    31. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
    32. Subir Bose & Ludovic Renou, 2014. "Mechanism Design With Ambiguous Communication Devices," Econometrica, Econometric Society, vol. 82(5), pages 1853-1872, September.
    33. Daniel Ellsberg, 1961. "Risk, Ambiguity, and the Savage Axioms," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 75(4), pages 643-669.
    34. Subrahmanyam, Avanidhar, 1991. "Risk Aversion, Market Liquidity, and Price Efficiency," The Review of Financial Studies, Society for Financial Studies, vol. 4(3), pages 416-441.
    35. Julian Kozlowski & Laura Veldkamp & Venky Venkateswaran, 2020. "The Tail That Wags the Economy: Beliefs and Persistent Stagnation," Journal of Political Economy, University of Chicago Press, vol. 128(8), pages 2839-2879.
    36. Peter Klibanoff & Massimo Marinacci & Sujoy Mukerji, 2005. "A Smooth Model of Decision Making under Ambiguity," Econometrica, Econometric Society, vol. 73(6), pages 1849-1892, November.
    37. Harrison Hong & Jeremy C. Stein, 1999. "A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets," Journal of Finance, American Finance Association, vol. 54(6), pages 2143-2184, December.
    38. repec:oup:restud:v:84:y::i:1:p:237-276. is not listed on IDEAS
    39. Kewei Hou & Chen Xue & Lu Zhang, 2020. "Replicating Anomalies," The Review of Financial Studies, Society for Financial Studies, vol. 33(5), pages 2019-2133.
    40. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
    41. Nicolas S. Lambert & Michael Ostrovsky & Mikhail Panov, 2018. "Strategic Trading in Informationally Complex Environments," Econometrica, Econometric Society, vol. 86(4), pages 1119-1157, July.
    42. RenÈ Caldentey & Ennio Stacchetti, 2010. "Insider Trading With a Random Deadline," Econometrica, Econometric Society, vol. 78(1), pages 245-283, January.
    43. Yongqiang Chu & David Hirshleifer & Liang Ma, 2020. "The Causal Effect of Limits to Arbitrage on Asset Pricing Anomalies," Journal of Finance, American Finance Association, vol. 75(5), pages 2631-2672, October.
    44. Ball, R & Brown, P, 1968. "Empirical Evaluation Of Accounting Income Numbers," Journal of Accounting Research, Wiley Blackwell, vol. 6(2), pages 159-178.
    45. Kfir Eliaz & Ran Spiegler, 2019. "The Model Selection Curse," American Economic Review: Insights, American Economic Association, vol. 1(2), pages 127-140, September.
    46. Galanis, S. & Ioannou, C. & Kotronis, S., 2019. "Information Aggregation Under Ambiguity: Theory and Experimental Evidence," Working Papers 20/05, Department of Economics, City University London.
    47. Gabriel Carroll, 2015. "Robustness and Linear Contracts," American Economic Review, American Economic Association, vol. 105(2), pages 536-563, February.
    48. Michaely, Roni & Thaler, Richard H & Womack, Kent L, 1995. "Price Reactions to Dividend Initiations and Omissions: Overreaction or Drift?," Journal of Finance, American Finance Association, vol. 50(2), pages 573-608, June.
    49. Kerry Back & C. Henry Cao & Gregory A. Willard, 2000. "Imperfect Competition among Informed Traders," Journal of Finance, American Finance Association, vol. 55(5), pages 2117-2155, October.
    50. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    51. Liyan Yang & Haoxiang Zhu, 2020. "Back-Running: Seeking and Hiding Fundamental Information in Order Flows," The Review of Financial Studies, Society for Financial Studies, vol. 33(4), pages 1484-1533.
    52. Han, Bing & Tang, Ya & Yang, Liyan, 2016. "Public information and uninformed trading: Implications for market liquidity and price efficiency," Journal of Economic Theory, Elsevier, vol. 163(C), pages 604-643.
    53. Holden, Craig W. & Subrahmanyam, Avanidhar, 1994. "Risk aversion, imperfect competition, and long-lived information," Economics Letters, Elsevier, vol. 44(1-2), pages 181-190.
    54. David Hirshleifer & Sonya Seongyeon Lim & Siew Hong Teoh, 2009. "Driven to Distraction: Extraneous Events and Underreaction to Earnings News," Journal of Finance, American Finance Association, vol. 64(5), pages 2289-2325, October.
    55. Chan, Louis K C & Jegadeesh, Narasimhan & Lakonishok, Josef, 1996. "Momentum Strategies," Journal of Finance, American Finance Association, vol. 51(5), pages 1681-1713, December.
    56. Foster, F Douglas & Viswanathan, S, 1996. "Strategic Trading When Agents Forecast the Forecasts of Others," Journal of Finance, American Finance Association, vol. 51(4), pages 1437-1478, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Philipp K. Illeditsch & Jayant V. Ganguli & Scott Condie, 2021. "Information Inertia," Journal of Finance, American Finance Association, vol. 76(1), pages 443-479, February.
    2. Massimo Guidolin & Francesca Rinaldi, 2013. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Theory and Decision, Springer, vol. 74(2), pages 183-217, February.
    3. Cosmin L. Ilut & Martin Schneider, 2022. "Modeling Uncertainty as Ambiguity: a Review," NBER Working Papers 29915, National Bureau of Economic Research, Inc.
    4. repec:esx:essedp:770 is not listed on IDEAS
    5. Agarwal, Vikas & Arisoy, Y. Eser & Naik, Narayan Y., 2017. "Volatility of aggregate volatility and hedge fund returns," Journal of Financial Economics, Elsevier, vol. 125(3), pages 491-510.
    6. Jiang, George J. & Zhu, Kevin X., 2017. "Information Shocks and Short-Term Market Underreaction," Journal of Financial Economics, Elsevier, vol. 124(1), pages 43-64.
    7. repec:esx:essedp:719 is not listed on IDEAS
    8. David Hirshleifer, 2001. "Investor Psychology and Asset Pricing," Journal of Finance, American Finance Association, vol. 56(4), pages 1533-1597, August.
    9. Nguyen, Pascal, 2005. "Market underreaction and predictability in the cross-section of Japanese stock returns," Journal of Multinational Financial Management, Elsevier, vol. 15(3), pages 193-210, July.
    10. Vayanos, Dimitri & Wang, Jiang, 2012. "Market liquidity - theory and empirical evidence," LSE Research Online Documents on Economics 119044, London School of Economics and Political Science, LSE Library.
    11. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    12. Doron Avramov & Guy Kaplanski & Avanidhar Subrahmanyam, 2022. "Postfundamentals Price Drift in Capital Markets: A Regression Regularization Perspective," Management Science, INFORMS, vol. 68(10), pages 7658-7681, October.
    13. Qi Nan Zhai, 2015. "Asset Pricing Under Ambiguity and Heterogeneity," PhD Thesis, Finance Discipline Group, UTS Business School, University of Technology, Sydney, number 1-2015, March.
    14. David Hirshleife, 2015. "Behavioral Finance," Annual Review of Financial Economics, Annual Reviews, vol. 7(1), pages 133-159, December.
    15. Guo, Liang, 2013. "Determinants of credit spreads: The role of ambiguity and information uncertainty," The North American Journal of Economics and Finance, Elsevier, vol. 24(C), pages 279-297.
    16. Sadka, Ronnie, 2006. "Momentum and post-earnings-announcement drift anomalies: The role of liquidity risk," Journal of Financial Economics, Elsevier, vol. 80(2), pages 309-349, May.
    17. Daniele Pennesi, 2013. "Asset Prices in an Ambiguous Economy," Carlo Alberto Notebooks 315, Collegio Carlo Alberto.
    18. Larry G. Epstein & Martin Schneider, 2010. "Ambiguity and Asset Markets," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 315-346, December.
    19. Jeong, Daehee & Kim, Hwagyun & Park, Joon Y., 2015. "Does ambiguity matter? Estimating asset pricing models with a multiple-priors recursive utility," Journal of Financial Economics, Elsevier, vol. 115(2), pages 361-382.
    20. Lars Peter Hansen, 2021. "Uncertainty Spillovers for Markets and Policy," Annual Review of Economics, Annual Reviews, vol. 13(1), pages 371-396, August.
    21. Alwathnani, Abdulaziz M. & Dubofsky, David A. & Al-Zoubi, Haitham A., 2017. "Under-or-overreaction: Market responses to announcements of earnings surprises," International Review of Financial Analysis, Elsevier, vol. 52(C), pages 160-171.
    22. Aliyev, Nihad & He, Xue-Zhong, 2023. "Ambiguous price formation," Journal of Mathematical Economics, Elsevier, vol. 106(C).

    More about this item

    Keywords

    Robust pricing; Strategic trading; Ambiguity; Underreaction to public information;
    All these keywords.

    JEL classification:

    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • G00 - Financial Economics - - General - - - General
    • G40 - Financial Economics - - Behavioral Finance - - - General

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jetheo:v:199:y:2022:i:c:s0022053121000181. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/622869 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.