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Return Predictability and Strategic Trading under Symmetric Information

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Document pages: 26 pages

Abstract: This paper develops a rational equilibrium model of strategic trading under symmetric information in which there is a liquidity provider and a strategic trader. The strategic trader considers the impact of his trades, the liquidity provider sets the stock price competitively, and there is a possibility that the value of the stock payoff will be revealed perfectly before the terminal date. Under certain conditions, we find that a buy (sale)-order by the strategic trader leads to positive (negative) stock returns in the future and that there exists a positive contemporaneous relationship between the stock return and the trades of the strategic trader. Under other conditions, we demonstrate that the stock exhibits positive (negative) returns following buying (selling) by the liquidity provider. We then introduce a trend chaser into the rational model. If trend chasing is weak, we show that the mechanical trend chaser can actually make a profit. If trend chasing is strong, the strategic trader is able to raise the stock prices by buying initially to attract the trend chaser and sells to the trend chaser later for profits.

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