Disagreement, Information, and Trade

Abstract

Asymmetries in information among rational traders are widely recognized as unable to explain observed levels of speculative trade in financial markets. Heterogeneous priors—in which agents “agree to disagree” about the likelihoods of different events, even contingent on the same information—have been posited to explain such trade. In a contractually rich, zero-sum setting, we explore the relationship between trade generated by heterogeneous priors and the distribution of information among traders. We establish a series of results showing that trade flows in the direction of disagreements and not the direction of private information. For instance, if a direction of trade generates surplus given some constellation of information, then (i) trade in that same direction can still generate surplus even if traders’ information were swapped, and (ii) with swapped information, trade in the opposite direction is never mutually agreeable so long as traders take full advantage of their disagreements. We note that failures to account for others’ information can explain trading patterns shown to be inconsistent with heterogeneous priors.