Trading Under Uncertainty About Other Market Participants

Abstract

I present an asymmetric information model of financial markets that features rational, but uninformed, hedge fund managers who trade against informed and noise traders. Managers are uncertain not only about fundamentals, but also about the proportion of informed to noise traders in the market and use prices to update their beliefs about these uncertainties. Extreme news leads to an increase in both types of uncertainty, while it decreases price informativeness. Prices react asymmetrically to positive and negative news, with higher expected returns at times of increased uncertainty about market composition. The model generates a price-volume relationship that is consistent with established stylized facts. I then extend to a three-period model and study the dynamics of expected returns and volatility.

Keywords: Asymmetric information, Price informativeness, Noise traders

JEL Classification: G11, G12, G14