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Man or Machine? Rational trading without information about fundamentals

We present a model of quantitative trading as an automated system under human supervision. Contrary to previous literature we show that price-contingent trading is the profitable equilibrium strategy of large rational agents in efficient markets. The key ingredient is uncertainty about whether a large trader is informed about fundamentals. Even when uninformed, he still learns more from prices than market participants who still wonder about whether he is informed. Therefore, he will trade a non-zero quantity based on past prices, whose direction – trend-following or contrarian – depends on parameters. When informed, he will trade on that information and disregard the algorithm. One implication is that future order flow is predictable even if markets are semi-strong efficient by construction.

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Paper provided by Imperial College, London, Imperial College Business School in its series Working Papers with number 12194.

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Date of creation: 31 Dec 2012
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Handle: RePEc:imp:wpaper:12194
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