Strategic Trading with Risk Aversion and Information Flow

Abstract

We analyze a dynamic auction model in which competitive risk-averse traders optimally exploit their long-lived homogeneous private information regarding the value of an asset. The asset's terminal value depends on both the traders’ initial signal and a sequence of zero-mean information shocks — private and/or public — that arrive at each auction. Traders balance the risks of noise trade imbalances, which can be avoided by trading early, and the risks of these persistent shocks, which can be avoided by trading later. Despite competition among the informed traders, observed trade patterns can resemble a “waiting game” rather than a “rat race”.

Keywords: informed trading, risk aversion, price efficiency, information flow, limits to arbitrage

JEL Classification: G14