An Equilibrium Model of Informed Trading and Portfolio Rebalancing

A key intuition of standard rational expectations models is that private information about future payoffs can by itself not generate trading. Trading is only possible if there is an additional motive for trading such as for example liquidity trading. In this paper I show how this misleading intuition results from an assumption that all of these models have in common: investors have negative exponential (CARA) utility functions. I develop a rational expectations equilibrium where uninformed investors are willing to trade with informed investors even though they know that they trade with someone who possesses superior information. ∗Anderson School of Business University of California, Los Angeles. I thank Anat Admati, Avanidhar Subrahmanyam, Bruce Lehman, and Alan Kraus, as well as seminar participants at UCLA and at the UBC Summer Finance Conference 2008.