Multidimensional Uncertainty and Hypersensitive Asset Prices

Abstract

We consider a dynamic asset pricing model with one asset, in which one informed trader trades against liquidity traders and competitive market makers. Informed trader has private information about the fundamental value of the asset as well as the exogenous demand shock on the market. We characterize the unique linear Markov equilibrium of the model. With just the private information about fundamentals the price converges to the fundamental value in a monotone way (Kyle ’85). We show that the model with arbitrarily small demand shocks exhibits a price bubble. The bubble is created for strategic reasons by the informed trader, who follows a so called pump-and-dump strategy. He initially exacerbates the demand shock, trading at a loss (contrarian behavior), and gains later on by trading at an inflated price. Finally, both payoff relevant and payoff irrelevant information is revealed to the market. (with Chris Woolnough)