Higher-order simulations: Strategic investment under model-induced market structures

Abstract

The trading and investment decision processes in financial markets becomes ever more dependent on the use of valuation and risk models. In certain, cases such as risk management, modelling practice has become so homogeneous that one is led to ask about the effect this has on the price formation process. Furthermore, should stable price patterns emerge from this, can sophisticated investors who have private information about the use and characteristics of these models make superior gains? The aim of this article is to test this hypothesis in a stylised market environment, where a strategic trader who trades on information about the valuation and risk management models used by competitors. Results show that for our particular market setting, such a strategy has an advantage over those that do not use this information.