On the sophistication of financial investors and the information revealed by prices

Does increasing the traders' understanding of the financial markets lead to their more orderly functioning? We provided an answer by studying a simple exchange economy with asymmetric information. Each trader was either a fundamentalist, who knew the probability distribution of random shocks, or a speculator trying to infer that distribution from asset prices. Starting with the unsophisticated beliefs that asset prices transfmitted no information, the speculators learned the mapping from asset prices to probabilities through adaptive observation. Our results characterized the necessary conditions for convergence to rational expectations equilibrium.