A Hidden Markov Model Approach to Information-Based Trading: Theory and Applications

71 Pages Posted: 28 Sep 2013

See all articles by Xiangkang Yin

Xiangkang Yin

Deakin University; Financial Research Network (FIRN)

Jing Zhao

La Trobe University - School of Economics and Finance; Financial Research Network (FIRN)

Multiple version iconThere are 2 versions of this paper

Date Written: May 9, 2013

Abstract

This paper develops a novel approach to information-based securities trading by characterizing the hidden state of the market, which varies following a Markov process. Extensive simulation demonstrates that the approach can successfully identify market states and generate measures of information-based trading that outperform prevailing models. A sample of 120 NYSE stocks further verifies that it can better depict trading dynamics. With this sample, we also characterize the features of information asymmetry and belief dispersion around earnings announcements and show that information-based trading prior to earnings announcements can significantly explain abnormal returns on announcement days and post-earnings-announcement drifts.

Keywords: Hidden Markov process, Information-based trading, Information asymmetry, Public information, Earnings announcement

JEL Classification: D82, G12, G14

Suggested Citation

Yin, Xiangkang and Zhao, Jing, A Hidden Markov Model Approach to Information-Based Trading: Theory and Applications (May 9, 2013). Available at SSRN: https://ssrn.com/abstract=2331792 or http://dx.doi.org/10.2139/ssrn.2331792

Xiangkang Yin

Deakin University ( email )

Melbourne, Victoria
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Jing Zhao (Contact Author)

La Trobe University - School of Economics and Finance ( email )

Dept of Economics and Finance
La Trobe University
Bundoora, VIC 3086
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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