Insider Trading, Stochastic Liquidity and Equilibrium Prices

Pierre Collin-Dufresne and Vyacheslav Fos

No 18451, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We extend Kyle's (1985) model of insider trading to the case where liquidity provided by noise traders follows a general stochastic process. Even though the level of noise trading volatility is observable, in equilibrium, measured price impact is stochastic. If noise trading volatility is mean-reverting, then the equilibrium price follows a multivariate 'stochastic bridge' process, which displays stochastic volatility. This is because insiders choose to optimally wait to trade more aggressively when noise trading activity is higher. In equilibrium, market makers anticipate this, and adjust prices accordingly. More private information is revealed when volatility is higher. In time series, insiders trade more aggressively, when measured price impact is lower. Therefore, execution costs to uninformed traders can be higher when price impact is lower.

JEL-codes: D4 D8 D80 D82 D83 D84 G0 G00 G1 G10 G12 G14 (search for similar items in EconPapers)
Date: 2012-10
New Economics Papers: this item is included in nep-mst and nep-ore
Note: AP CF EFG
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Citations: View citations in EconPapers (9)

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