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Rogue traders

Author

Listed:
  • Huayuan Dong

    (National University of Singapore)

  • Paolo Guasoni

    (Dublin City University
    Università di Bologna)

  • Eberhard Mayerhofer

    (University of Limerick)

Abstract

Investing on behalf of a firm, a trader can feign personal skill by committing fraud that with high probability remains undetected and generates small gains, but with low probability bankrupts the firm, offsetting ostensible gains. Honesty requires enough skin in the game: if two traders with isoelastic preferences operate in continuous time and one of them is honest, the other is honest as long as the respective fraction of capital is above an endogenous fraud threshold that depends on the trader’s preferences and skill. If both traders can cheat, they reach a Nash equilibrium in which the fraud threshold of each of them is lower than if the other one were honest. More skill, higher risk aversion, longer horizons and higher volatility all lead to honesty on a wider range of capital allocations between the traders.

Suggested Citation

  • Huayuan Dong & Paolo Guasoni & Eberhard Mayerhofer, 2023. "Rogue traders," Finance and Stochastics, Springer, vol. 27(3), pages 539-603, July.
    • Handle: RePEc:spr:finsto:v:27:y:2023:i:3:d:10.1007_s00780-023-00507-z
    DOI: 10.1007/s00780-023-00507-z
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Rogue trading; Internal fraud; Operational risk; Stochastic differential games;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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