Modelling Information Flows in Financial Markets

The major determiner of price changes is new information. When a new piece of information circulates in a financial market (whether true, partly true, misleading, or bogus), the prices of related assets are adjusted in re-sponse. In this talk I discuss some of the issues involved in modelling the flow of information in financial markets, and I present some elementary models for information in various situations. Some applications to the pricing of various types of financial products will be indicated. In particular I shall look at dynamic models for stochastic volatility and correlation. Finally, I shall make a few remarks about statistical arbitrage strategies, and about price formation in inhomogeneous markets. The approach taken as regards the role of filtering in finance can be summarized in more detail as follows. We take the view that financial assets are defined by the cash flows that they generate. Each cash flow is modelled by a random variable that can be ex-pressed as a function of a collection of independent random variables called market factors. With each such X-factor we associate a so-called marke