| Ramdan Dridi, London School of Economics Laurent Germain, London Business School |
| Bullish-Bearish Strategies of Trading: A Nonlinear Equilibrium |
| Session: C-8-21 Monday 14 August 2000 by Dridi, Ramdan |
| In this paper, we study a financial market where risk neutral traders are endowed with a signal which is perfectlyrevealing of the direction (but not the exact amount) of the liquidation value of a normally distributed risky asset. This type of infor- mation is known as bullish or bearish. When the signal is positive (negative) the traders buy (sell) the asset. Trading recommendations issued by financial institu- tions fall into this category of information. At the equilibrium, the optimal strategy consists of buying (selling) when bullish (bearish) a fixed quantity of the asset. The market makers observe the aggregated volume submitted by the informed traders and the noise traders. In this model, since the optimal trading strategy is not lin- ear, the pricing schedule is also a nonlinear function of the volumes. We show i) that the price function is a nonlinear S-shaped function. ii) that price pressure is a regular bell-shaped curve of the volumes. Both i) and ii) are consistent with empir- ical findings. iii) A monopolistic bullish-bearish type trader makes nearly thirty six percent of the profits she would have made with a perfect signal in a linear model a la Kyle (1985). iv) In the presence of competition, the market reveals his private information quicker than in a perfectly informed strategic oligopoly. |