What drives information dissemination in continuous double auction markets?

Abstract

In this paper, we investigate further the way information disseminates from informed to uninformed traders in a market populated by heterogeneous boundedly rational agents. In order to achieve the goal, a computer simulated market where only a small fraction of the population observe the risky asset's fundamental value with noise was constructed, while the rest of agents try to forecast the asset's price from past transaction data. The paper departs from previous studies in that the risky asset does not pay a dividend every period, so agents cannot learn from past transaction prices and subsequent dividend payments. The main finding is that information can potentially disseminate in the market as long as: (1) informed investors' trades tilt transaction prices in the fundamental path direction; and (2) the median investor's expectation is very responsive to transaction prices. Otherwise, markets may display crashes or bubbles. It is found that the first condition requires a minimal amount of informed investors, and is severely limited by short selling and borrowing constraints.