Fundamental Analysis and Hedge Trading in a Disagreement Model

41 Pages Posted: 20 Sep 2008

See all articles by Russell J. Lundholm

Russell J. Lundholm

University of British Columbia - Sauder School of Business

Date Written: September, 19 2008

Abstract

In this paper I present a simple model where hedge traders meet fundamental traders in a competitive stock market. The key distinction between the two trader groups is that hedge traders evaluate information on a relative basis while fundamental traders evaluate information on an absolute basis. In particular, hedge traders rank-order stocks based on a signal and form a long/short portfolio. Fundamental traders observe the same underlying signals as the hedge traders but use the information very differently. Fundamental traders understand the relation between each firm's signal and its future cash flows and use this to create a value estimate for each stock. They compare the value estimate to the firm's price and make a decision to buy or sell the stock based on this comparison. The model makes predictions about how the aggressiveness of the hedge traders, the informativeness of the signals, and the mix of investor types influence the efficiency in the market and the expected profits to a hedge-trading or fundamental analysis strategy.

Keywords: hedge trading, financial statement analysis

JEL Classification: G12, G14, M41

Suggested Citation

Lundholm, Russell J., Fundamental Analysis and Hedge Trading in a Disagreement Model (September, 19 2008). AAA 2009 Financial Accounting and Reporting Section (FARS) Paper. Available at SSRN: https://ssrn.com/abstract=1270758 or http://dx.doi.org/10.2139/ssrn.1270758

Russell J. Lundholm (Contact Author)

University of British Columbia - Sauder School of Business ( email )

2053 Main Hall
Vancouver, British Columbia V6T 1Z2
Canada

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