Rogue Traders

47 Pages Posted: 8 Jul 2021 Last revised: 22 Jul 2021

See all articles by Huayuan Dong

Huayuan Dong

Dublin City University - School of Mathematical Sciences

Paolo Guasoni

Boston University - Department of Mathematics and Statistics; Dublin City University - School of Mathematical Sciences; University of Bologna - Department of Statistics

Eberhard Mayerhofer

University of Limerick - Department of Mathematics and Statistics

Date Written: June 20, 2021

Abstract

Investing on behalf of a firm, a trader can feign personal skill by committing fraud that with high probability remains undetected and generates small gains, but that with low probability bankrupts the firm, offsetting ostensible gains. Honesty requires enough skin in the game: if two traders with isoelastic preferences operate in continuous-time and one of them is honest, the other is honest as long as the respective fraction of capital is above an endogenous fraud threshold that depends on the trader’s preferences and skill. If both traders can cheat, they reach a Nash equilibrium in which the fraud threshold of each of them is lower than if the other one were honest. More skill, higher risk aversion, longer horizons, and greater volatility all lead to honesty on a wider range of capital allocations between the traders.

Keywords: rogue trading, internal fraud, operational risk, stochastic differential games

JEL Classification: G11

Suggested Citation

Dong, Huayuan and Guasoni, Paolo and Guasoni, Paolo and Mayerhofer, Eberhard, Rogue Traders (June 20, 2021). Michael J. Brennan Irish Finance Working Paper Series Research Paper No. 21-8, Available at SSRN: https://ssrn.com/abstract=3870658 or http://dx.doi.org/10.2139/ssrn.3870658

Huayuan Dong

Dublin City University - School of Mathematical Sciences ( email )

Dublin
Ireland

Paolo Guasoni (Contact Author)

Boston University - Department of Mathematics and Statistics ( email )

Boston, MA 02215
United States

Dublin City University - School of Mathematical Sciences ( email )

Dublin
Ireland

HOME PAGE: http://www.guasoni.com

University of Bologna - Department of Statistics ( email )

Bologna, 40126
Italy

Eberhard Mayerhofer

University of Limerick - Department of Mathematics and Statistics ( email )

Castletroy, Co
Limerick
Ireland

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