A Dynamic Model of Information Selection in Asset Markets

David Goldbaum - George Washington University

This paper develops a dynamic model to examine whether the use of a technical trading rule is sustainable in an asset market where traders endogenously choose from different information sources to maximize expected profits. There are three sources of information available to investors. At a premium, investors can obtain a noisy, but rumor-free, signal of next period=92s dividend. At no charge, the trader can receive. A similar signal with the distinction that this information source is apt to follow a rumor, allowing for a bias to develop in the signal. The final option, also without charge, is to use a simple trading rule constructed from past and current price patterns. In choosing between the two fundamental information signals, traders form expectations of the total benefits to obtaining each signal. The bias and differences in the accuracy of the two signals creates discrepancies between the beliefs of these two groups of fundamentally informed traders. A greater bias leads to increased trading volume.

Through observing past trading volume, traders can estimate the magnitude, though not the direction of the bias. Forward looking agents will elect to avoid paying the premium, choosing the second signal, if the bias is believed to be small. When the bias is large and trading volume is high, traders can deduce that the rumor is far from the truth and will switch to the first signal. With a high proportion of the traders using the first signal, the rumor is essentially dispelled, allowing traders to return to the second signal next period.

Traders evaluate the trading rules relative to the two fundamental signals based on past performance. In order for the trading rule to be consistently used by a population of traders, it has to consistently perform as well as the fundamental information.

In computer simulations, all information sources are used by traders, which one depends on the perceived state of the market. A mixed strategy where investors at times make use of the trading rules is found to generate higher returns than pure strategies based on the fundamental information. The trading rules are unable to dominate the market because, in order to function, the market clearing price must reflect the information obtained by the fundamental traders.

Scheduled for Session 3.4 Financial Models - II