Abstract
We model a scenario in which there are three types of investors: fundamentalists, speculators, and trend-followers and an intermediary who cares about his reputation. Fundamentalists are rational investors with long horizons who are interested in the dividend stream. Speculators are rational investors who have short horizons and are interested in profiting from short-term price movements or capital gains. Trend-followers are behavioral investors who extrapolate price trends, and, consequently, are late entrants in the market. We show that an informed intermediary (broker) can manipulate demand (consequently stock price) without losing his reputation when there is information asymmetry. We also show that there is a trade-off between broker level competition for reputation and market liquidity. Broker level competition checks manipulation, but it adversely affects market liquidity.
Highlights
Trend-followers are investors who extrapolate price trends
We show that if trend-followers are present, and investors have different investment horizons, a coordination game is created in which short horizon investors want to coordinate with long horizon investors
We show that there is a trade-off between broker level competition needed to check manipulation, and market liquidity
Summary
Trend-followers are investors who extrapolate price trends. Academic research on trend-followers is mostly concerned with measuring the profitability of trend-following strategies (see Cheung 1997; Menkhoff and Schlumberger 1995; Levich and Thomas 1993; Sweeny 1986 among others). As shown in Jung (2009b), the idea underlying Jung’s model is general; if there is a coordination game between two parties with asymmetric information, a third party with powers to reduce asymmetry can manipulate equilibrium outcomes We apply this idea to financial markets and study a coordination game between investors with different investment horizons and different times of entry, and with an intermediary with powers to reduce asymmetry through signaling. Investor 2 reads the report in the same fashion as providing a signal about investor 1 Conditional on maintaining his credibility (by correctly forecasting the direction of the market), the broker wants to manipulate demand.
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