Lecture 2 Behavioral Finance

Bayesian Learning
The Sequential Trading Model of Glosten and Milgrom (1985)

Market Dynamics: The Revelation of Private Information Through Trading
Behavioral Finance
Lecture 2
The Revelation of Private Information Through Trading
Dr. Markus Demary
Ulm University
Summer Term 2021
Dr. Markus Demary Behavioral Finance

Bayesian Learning
1 Bayesian Learning
1 The Sequential Trading Model of Glosten and Milgrom (1985)

Assumptions
Graphical Description of the Model
Algebraic Description of the Model
Market Maker Quotes Bid and Ask Prices
1 Market Dynamics: The Revelation of Private Information Through Trading

Bayesian Learning
The Revelation of Private Information
Teaching Goals
∙ Students should learn how private information is incorporated into asset prices
∙ that adverse selection in financial markets give rise to the bid-ask spread
The Model of Glosten and Milgrom (1985)
∙ Simple market microstructure model with strategic interaction

∙ sequential trading process, quote-driven market
∙ asymmetrically informed agents
Implications of the Model
∙ Endogenous bid-ask spread through adverse selection

∙ private information is incorporated into prices through trading
−→ prices converge to the full-information value
∙ the semi-strong form of market efficiency holds
−→ prices are martingales with respect to public information

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
Bayesian Learning
Example
∙ Assume that 2 percent of the population have caught an infectious desease (base rate)
∙ A new test identifies 95 out of 100 infectious people correctly and 95 out of 100
non-infectious people correctly
If a person tests positive, what is the probability of being infectious?
∙ If 1000 people will be tested each one day, 20 are expected to be infectious, but not
identified as infectious
∙ after the test all but one of the infectious will be identified (0.95 · 20 = 19), one is
false-negative (0.05 · 20 = 1)
∙ 49 out of 980 are false-positive (0.05 · 980 = 49), while 931 are correctly identified as
non-infectious
The accuracy of the test
∙ we expect a total of 19 + 49 = 68 positive test, of which 100 · 19/68 = 27.9 percent are
infectious and 72.1 percent are false-positive
∙ we expect a total of 1 + 931 = 932 negative tests, of which 100 · 1/932 = 0.11 percent are
false-negative

Bayesian Learning
Expected frequency tree

Base rate: 2 percent, test accuracy: 95 percent
Tested
positive 19
20
Infectious
Tested 1
negative
1000
Tested
positive 49
Non-
infectious
980
Tested 931
negative

Bayesian Learning
Reversed expected frequency tree

Infectious
19
68
Tested
positive
Non- 49
infectious
1000
Infectious
1
Tested
negative
932
Non- 931
infectious

Bayesian Learning
Bayesian Learning
Probability of testing positive given being infectious
∙ P (test = positive|infectious) = 0.95

∙ 95 percent of the infectious people will be detected by the test
Probablity of being infectious given positive test
∙
P (infectious|test = positive)
P (positive|infectious) · P (infectious)
=
P (positive|infectious) · P (infectious) + P (positive|non-infectious) · P (non-infectious)
0.95 · 0.02
=
0.95 · 0.02 + 0.05 · 0.98
0.019 0.019
= =
0.019 + 0.049 0.068
= 0.279
∙ we got 19 + 49 = 68 positive tests of which 19 (27.9 percent) were based on infectious
persons

Bayesian Learning
Reversed expected frequency tree

Tested
positive 95
100
Infectious
Tested 5
negative
1000
Tested
positive 45
Non-
infectious
900
Tested 855
negative

Bayesian Learning
Bayesian Learning
Probability of testing positive given being infectious
∙ P (test = positive|infectious) = 0.95

∙ 95 percent of the infectious people will be detected by the test
Probablity of being infectious given positive test
∙
P (infectious|test = positive)
P (positive|infectious) · P (infectious)
=
P (positive|infectious) · P (infectious) + P (positive|non-infectious) · P (non-infectious)
0.95 · 0.1
=
0.95 · 0.01 + 0.05 · 0.9
0.095 0.095
= =
0.095 + 0.045 0.14
= 0.679
∙ we got 95 + 45 = 140 positive tests of which 95 (67.9 percent) were based on infectious
persons

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
Assumptions
Glosten/Milgrom (1985)
Three types of traders and asymmetric information
∙ insiders know the fundamental value: percentage fraction pI

∙ liquidity traders do not know the fundamental value: percentage fraction pL = 1 − pI
∙ market makers do not know the fundamental value: set bid and ask prices
Market makers quote bid and ask prices
∙ competitive environment: have to fulfill zero-profit condition

∙ make losses by trading with informed traders (insiders)
∙ have to make profits by trading with uninformed liquidity traders for compensating losses
Asymmetric information leads to adverse selection
∙ market maker does not like to trade with informed agents

∙ the financial market will break down, when there are too much informed agents, since the
market maker has to set a huge bid-ask-spread

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (I)

Unobser- Unobser- Observable
vable Value vable Type Action
tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(B|U,VH)=0.5 Buy Order
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
Asset Value P(S|U,VH)=0.5
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
P(B|U,VL)=0.5 Buy Order
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (II)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Asset can either be

in good state or in Good State
bad state P(B|U,VH)=0.5 Buy Order
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (III)

tradertype
a
Prior probability for P(B|I,VH) = 1
the asset to be in Informed Buy Order
good state P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (IV)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Prior probability for Uninformed

P(U)
the asset to be in trader
bad state
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (V)

Probability of
trading with an
informed trader
tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (VI)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
Probability of
trading with an
uninformed trader P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (VII)

The informed trader
buys when asset is
Unobser- Unobser- in good state Observable
tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (VIII)

tradertype
The uninformed
a
trader flips
P(B|I,V a coin
H) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (IX)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed The informed trader
trader sells when asset is
in bad state Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (X)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
The uninformed
P(S|I,Vflips
trader L) = 1
a coin
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XI)

tradertype
a
P(B|I,VH) = 1 The market maker
Informed onlyBuy
observes
Order
P(I) trader actions
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XII)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
The market maker trader
aims at learning the
Sell Order
true asset value
from the actions of
traders
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XIII)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
Trading with 0,5
P(VH)
P(U) informed traders
Uninformed
leadstrader
to losses but
reveals information
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XIV)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
Trading with uninformed
traders reveals no
information, but yields profits P(S|I,VL) = 1
Informed
for offsetting the losses from Sell Order
P(I) trader traders
trading with informed
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XV)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
P(I) trader
Good State
P(VH) 0,5
P(U) Uninformed
trader
Market maker sets ask prices
Sell Order
Asset Value P(S|U,VH)=0.5 such that trading with
informed and uninformed
buyers leads to zero profits
P(S|I,VL) = 1
(under perfect competition)
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XVI)

tradertype
a
P(B|I,VH) = 1
Informed Buysets
Market maker Order
bid prices
P(I) trader such that trading with
informed and uninformed
Good State sellers leads to zero profits
(under perfect competition)
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
Graphical Description of Glosten/Milgrom (1985) (XVII)

tradertype
a
P(B|I,VH) = 1
Informed Buy Order
Bid and ask prices converge to
P(I) trader
the true asset value because
the market maker learns its
Good State
value from trading with
informed traders P(B|U,VH)=0.5 Buy Order
P(VH) 0,5
P(U) Uninformed
trader
Sell Order
P(S|I,VL) = 1
Informed Sell Order
P(I) trader
P(VL)
Bad State
Uninformed
P(U)
trader
Sell Order
P(S|U,VL)=0.5

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
Assumptions (I)
Nature chooses the fundamental asset value

∙ two possible values: p ∈ {VL , VH }, with VL < VH
Information is asymmetrically distributed among traders

∙ Market makers only know the prior probabilities
∙ Prob(VH ) = Θ
∙ Prob(VL ) = 1-Θ
∙ Informed traders know the asset value (VH here) with certainty
∙ Prob(VH ) = 1
∙ Prob(VL ) = 0

Bayesian Learning
Assumptions (II)
Market orders of informed and uninformed traders

∙ Informed traders
∙ buy if pA < VH
∙ sell if pB > VL
∙ Uninformed traders
∙ buy with probability 0.5
∙ sell with probability 0.5

Bayesian Learning
Market Makers and their Clients (I)

Sequential trading process
∙ clients (insiders and liquidity traders) appear sequentially as a random draw

∙ market makers cannot predict if they trade with an informed or an
uninformed trader
Adverse selection
∙ market makers realize losses by trading with an informed trader (otherwise
the informed trader would not trade)
∙ have to set quotes (bid and ask prices) such that they realize profits by
trading with uninformed traders

Bayesian Learning
Market Makers and their Clients (II)

Perfect competition and risk-neutrality imply
∙ trading with buyers: E[profit|B] = pA − E[V |B] = 0 ⇐= pA = E[V |B]

∙ trading with sellers: E[profit|S] = pB − E[V |S] = 0 ⇐= pB = E[V |S]
Market maker quotes bid and ask prices
∙ pA = E[V |B] = VL · P (VL |B) + VH · P (VH |B)

∙ pB = E[V |S] = VL · P (VL |S) + VH · P (VH |S)

Bayesian Learning
Inferring Information from a Buyer (I)

Market maker trades with a buyer
∙ Does trading with a buyer convey information about the asset being in the good state?
What is the probability that the asset is in the good state?
P (VH ) · P (B|VH )
P (VH |B) = (1)
P (B)
∙ P (VH |B): probability that asset is in the good state given that the client is a buyer
∙ P (VH ): prior probability that asset is in the good state
∙ P (B|VH ): probability that a buyer appears, when the asset is in the good state
∙ P (B): probability that the client is a buyer

Bayesian Learning
Inferring Information from a Buyer (II)

Market maker trades with a buyer
∙ does trading with a buyer convey information that the asset is in the bad state?
What is the probability that the asset is in the bad state?
P (VL ) · P (B|VL )
P (VL |B) = = 1 − P (VL |B) (2)
P (B)
∙ P (VL |B): probability that asset is in the bad state given that the client is a buyer
∙ P (VL ): prior probability that asset is in the bad state
∙ P (B|VL ): probability that a buyer appears, when the asset is in the bad state
∙ P (B): probability that the client is a buyer

Bayesian Learning
Inferring Information from a Seller (I)

Market maker trades with a seller
∙ does trading with a seller convey information that the asset is in the good state?
P (VH ) · P (S|VH )
P (VH |S) = (3)
P (S)
∙ P (VH |S): probability that asset is in the good state given that the client is a seller
∙ P (VH ): prior probability that asset is in the good state
∙ P (S|VH ): probability that a seller appears, when the asset is in the good state
∙ P (S): probability that the client is a seller

Bayesian Learning
Inferring Information from a Seller (II)

Market maker trades with a seller
∙ does trading with a seller convey information that the asset is in the bad state?
P (VL ) · P (S|VL )
P (VL |S) = (4)
P (S)
∙ P (VL |S): probability that asset is in the bad state given that the client is a seller
∙ P (VL ): prior probability that asset is in the bad state
∙ P (S|VL ): probability that a seller appears, when the asset is in the bad state
∙ P (S): probability that the client is a seller

Bayesian Learning
When is a Client Most Likely a Buyer?

Probability that client is a buyer

∙ client is an informed trader with probability pI
∙ informed trader is a buyer when asset is in the good state
∙ probability that the asset is in the good state Θ
∙ client is an uninformed trader with probability 1 − pI
∙ liquidity trader is a buyer with probability 0.5
∙ hence, the unconditional probability that a client is a buyer is
P (B) = P (B|VH ) · P (VH ) + P (B|VL ) · P (VL ) (5)

= (pI · 1 + (1 − pI ) · 0.5) · Θ + ((1 − pI ) · 0.5) · (1 − Θ) (6)
= pI Θ + (1 − pI )0.5 (7)

Bayesian Learning
When is a Client Most Likely a Seller?

Probability that client is a seller

∙ client is an informed trader with probability pI
∙ informed trader is a seller when asset is in the bad state
∙ probability that the asset is in the bad state 1 − Θ
∙ client is an uninformed trader with probability 1 − pI
∙ liquidity trader is a seller with probability 0.5
∙ hence, the unconditional probability that a client is a seller is
P (S) = P (S|VH ) · P (VH ) + P (S|VL ) · P (VL ) (8)

= (1 − pI ) · 0.5 · Θ + (pI · 1 + (1 − pI ) · 0.5) · (1 − Θ) (9)
= (1 − pI ) · 0.5 + pI (1 − Θ) (10)

Bayesian Learning
Conditional Probability of Being a Buyer

Unconditional probability of client being a buyer
P (B) = (1 − pI )0.5 + pI Θ (11)
Probability that client is a buyer when asset is in the good state
∙ informed trader buys the asset when it is in the good state Θ = 1

∙ uninformed trader is a buyer with probability 0.5
P (B|VH ) = (1 − pI )0.5 + pI (12)
Probability that client is a buyer when asset is in the bad state
∙ informed trader does not buy the asset, when it is in the bad state Θ = 0
∙ uninformed trader buys the asset with probability 0.5
P (B|VL ) = (1 − pI )0.5 (13)

Bayesian Learning
Conditional Probability of Being a Seller

Unconditional probability of client being a seller
P (S) = (1 − pI )0.5 + pI (1 − Θ) (14)
Probability that client is a seller when asset is in the good state
∙ informed trader does not the asset when it is in the bad state 1 − Θ = 0
∙ uninformed trader is a buyer with probability 0.5
P (S|VH ) = (1 − pI )0.5 (15)
Probability that client is a seller when asset is in the bad state
∙ informed trader sells the asset, when it is in the bad state Θ = 0

∙ uninformed trader sells the asset with probability 0.5
P (S|VL ) = (1 − pI )0.5 + pI (16)

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning

Bid and ask prices
pa = E[p|B] = VL · P (VL |B) + VH · P (VH |B) (17)

pb = E[p|S] = VL · P (VL |S) + VH · P (VH |S) (18)
Probability that the asset is in a good state when a buyer appears
Θ((1 − pI )0.5 + pI )
P (VH |B) = (19)
(1 − pI )0.5 + ΘpI
Probability that the asset is in a good state when a seller appears
Θ((1 − pI )0.5)
P (VH |S) = (20)
(1 − pI )0.5 + (1 − Θ)pI

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
1 Bayesian Learning

Assumptions

Bayesian Learning
Market Dynamics: The Revelation of Private Information

After the first trade
∙ market makers revise their beliefs of the fundamental asset value

∙ set bid and ask quotes for the second trade
Bayesian updating of beliefs
∙ Probability of asset being in good state

new=
P (VH |B) after trading with a buyer
Θ (21)
P (VH |S) after trading with a seller
∙ Probability of trading with a buyer
new=
(1 − pI )0.5 + pI P (VH |B) after trading with a buyer
P (B) (22)
(1 − pI )0.5 + pI P (VH |S) after trading with a seller
∙ Probability of asset being in good state given buy order
P (B|VH )Θnew
P (VH |B) = (23)
P (B)new
∙ Probability of asset being in good state given sell order
P (S|VH )Θnew
P (VH |S) = (24)
P (S)new

Bayesian Learning
Market Dynamics: Example
V=100 0.8 Informed trader 1 Buy order
0.6 Good state
0.5 Buy order
0.2 Liquidity trader
Sell order
0.5
Asset value
0.8 Informed trader 1 Sell order
0.4 Bad state

0.5 Buy order
V=0 0.2 Liquidity trader
0.5 Sell order

Bayesian Learning

Initial conditions
Before the first trade
∙ asset price: pA = pB = E[V ] = 0.6 · 100 + 0.4 · 0 = 60

∙ share of informed traders: pI = 0.8
∙ share of liquidity traders: 1 − pI = 0.2
First trader is a buyer
∙ probability of trading with a buyer: P (B) = 0.8 · 0.6 + 0.2 · 0.5 = 0.58
∙ probability of trading with a buyer in the good state: P (B|VH ) = 0.8 · 0.6 + 0.2 = 0.68
∙ probability of trading with a buyer in the bad state: P (B|VL ) = 0.2 · 0.5 = 0.10
Updated probability that asset is in the good state
P (B|VH ) · P (VH ) 0.68 · 0.6

P (VH |B) = = = 0.703 (25)
P (B) 0.58

Bayesian Learning
0.703 Good state
0.5 Buy order
Sell order
0.5
Asset value
0.297 Bad state

0.5 Buy order
0.5 Sell order

Bayesian Learning

Next trade
Before the second trade
∙ asset price: pA = 0.703 · 100 + 0.297 · 0 = 70.3 and pB = 60

Second trader is a buyer
∙ probability of trading with a buyer in the good state:
P (B|VH ) = 0.8 · 0.703 + 0.2 = 0.7624
P (B|VH ) · P (VH ) 0.7624 · 0.703

P (VH |B) = = = 0.812 (26)
P (B) 0.66

Bayesian Learning
0.812 Good state
0.5 Buy order
Sell order
0.5
Asset value
0.188 Bad state

0.5 Buy order
0.5 Sell order

Bayesian Learning

Next trade
Before the third trade

Third trader is a buyer
∙ probability of trading with a buyer in the good state:
P (B|VH ) = 0.8 · 0.812 + 0.2 = 0.0.8469
P (B|VH ) · P (VH ) 0.8469 · 0.812

P (VH |B) = = = 0.917 (27)
P (B) 0.7496

Bayesian Learning
0.917 Good state
0.5 Buy order
Sell order
0.5
Asset value
0.083 Bad state

0.5 Buy order
0.5 Sell order

Bayesian Learning

Next trade
Before the fourth trade

Fourth trader is a seller
∙ probability of trading with a buyer: P (S) = 0.8 · 0.083 + 0.2 · 0.5 = 0.1664
∙ probability of trading with a buyer in the good state: P (S|VH ) = 0.2 · 0.5 = 0.1
∙ probability of trading with a buyer in the bad state: P (S|VL ) = 0.2 · 0.5 + 0.8 = 0.9
P (S|VH ) · P (VH ) 0.1 · 0.917

P (VH |S) = = = 0.551 (28)
P (S) 0.1664

Bayesian Learning

After four trades
Before the fifth trade
∙ asset price: pA = 91.7 and pB = 55.1

Convergence of the market price
∙ initially the good state was more likely than the bad state P (VH ) = 0.6
∙ the ask price was driven upwards by three buyers to pA = 91.7
∙ the bid price was driven downwards by one seller to pB = 55.1
∙ the market price after four trades is 0.5 · pA + 0.5 · pB = 73.4
∙ after four rounds buyers will appear with a higher probability than sellers
P (B) = 0.8336 > P (S) = 0.1664 the higher probability of buy orders will drive the
ask-price and thereby the market price towards its true value of VH = 100

Lecture 2 Behavioral Finance

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Bayesian Learning

The Sequential Trading Model of Glosten and Milgrom (1985)

Dr. Markus Demary

Summer Term 2021

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

The Revelation of Private Information

The Model of Glosten and Milgrom (1985)

∙ Simple market microstructure model with strategic interaction

Implications of the Model

∙ Endogenous bid-ask spread through adverse selection

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

If a person tests positive, what is the probability of being infectious?

The accuracy of the test

Dr. Markus Demary Behavioral Finance

Expected frequency tree

Dr. Markus Demary Behavioral Finance

Reversed expected frequency tree

Dr. Markus Demary Behavioral Finance

Probability of testing positive given being infectious

∙ P (test = positive|infectious) = 0.95

Probablity of being infectious given positive test

Dr. Markus Demary Behavioral Finance

Reversed expected frequency tree

Dr. Markus Demary Behavioral Finance

Probability of testing positive given being infectious

∙ P (test = positive|infectious) = 0.95

Probablity of being infectious given positive test

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

Three types of traders and asymmetric information

∙ insiders know the fundamental value: percentage fraction pI

Market makers quote bid and ask prices

∙ competitive environment: have to fulﬁll zero-proﬁt condition

Asymmetric information leads to adverse selection

∙ market maker does not like to trade with informed agents

Dr. Markus Demary Behavioral Finance

1 The Sequential Trading Model of Glosten and Milgrom (1985)

1 Market Dynamics: The Revelation of Private Information Through Trading

Dr. Markus Demary Behavioral Finance

Graphical Description of Glosten/Milgrom (1985) (I)

Dr. Markus Demary Behavioral Finance

Graphical Description of Glosten/Milgrom (1985) (II)

Asset can either be

Dr. Markus Demary Behavioral Finance

Graphical Description of Glosten/Milgrom (1985) (III)

Dr. Markus Demary Behavioral Finance