Self-Generating Trade and Rational Fads: The Response of Price to New Information
The dynamic behavior of security prices is studied in a setting where two agents trade strategically and learn from market prices. Each trader receives a private signal about fundamentals, the significance of which depends on the signal received by the other trader. In trading, each agent wants to deceive the other trader into revealing his signal, while not revealing his own signal. We show that trade is self-generating because agents learn the value of the asset only through observation of the market price. Uninformed agents, technical analysts, can also trade by charting past prices. These chartists ensure market efficiency. Equilibrium price paths of the model may display reversals in which all traders rationally revise their beliefs, first in one direction and then in the opposite direction even though no new information has entered the system. A piece of information which is initially thought to be bad news may be revealed, through trading, to be good news. This fad-like behavior results from rational strategic interaction and Bayesian inference. In this model security prices do not follow a martingale.
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