Strategic Informed Trades, Diversification, and Expected Returns

Posted: 27 Feb 2012 Last revised: 7 Jan 2015

Judson Caskey

University of California, Los Angeles (UCLA) - Accounting Area

John S. Hughes

University of California at Los Angeles

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management

Date Written: December 7, 2014

Abstract

We examine how strategic trade affects expected returns in a large economy. In our model, both a monopolist (strategic) informed trader and uninformed traders consider the impact of their demands on prices. In contrast to settings with price-taking traders, private information never eliminates a priced risk, and can lead to higher risk premiums. Also unlike settings with price-taking informed traders, risk premiums decrease in response to an increase in liquidity-motivated trades in diversified portfolios. These differing effects arise because a privately informed strategic trader conceals her trades by taking small positions relative to the magnitude of noise trades. Although prices partially reveal her information and reduce uncertainty, a concomitant decrease in her risk absorption dominates and leads to higher risk premiums. Similar to settings with price-taking traders, private information affects expected returns only via factor loadings and risk premiums on existing payoff risks – it introduces no new priced risks and factor loadings (betas) explain all cross-sectional differences in expected returns.

Suggested Citation

Caskey, Judson and Hughes, John S. and Liu, Jun, Strategic Informed Trades, Diversification, and Expected Returns (December 7, 2014). Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2011895 or http://dx.doi.org/10.2139/ssrn.2011895

Judson Caskey (Contact Author)

University of California, Los Angeles (UCLA) - Accounting Area ( email )

D410 Anderson Complex
Los Angeles, CA 90095-1481
United States

HOME PAGE: http://sites.google.com/site/judsoncaskey/

John S. Hughes

University of California at Los Angeles ( email )

D410 Anderson Complex
Los Angeles, CA 90095-1481
United States
310-794-9553 (Phone)
310-267-2193 (Fax)

Jun Liu

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States
858.534.2022 (Phone)
5858.534.0745 (Fax)

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