An Equilibrium Model of Informed Trading and Portfolio Rebalancing
45 Pages Posted: 25 Jan 2009 Last revised: 19 Mar 2009
Date Written: January 24, 2009
A key intuition of standard rational expectations models is that private information about future payoffs can by itself not generate trading. Trading is only possible if there is an additional motive for trading such as for example liquidity trading. In this paper I show how this misleading intuition results from an assumption that all of these models have in common: investors have negative exponential (CARA) utility functions. I develop a rational expectations equilibrium where uninformed investors are willing to trade with informed investors even though they know that they trade with someone who possesses superior information.
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