INSIDER TRADING WITH TEMPORARY PRICE IMPACT

Weston Barger () and Ryan Donnelly
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Weston Barger: Department of Applied Mathematics, University of Washington, Seattle, Washington 98195, USA
Ryan Donnelly: Department of Mathematics, King’s College London, Strand, London, WC2R 2LS, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2021, vol. 24, issue 02, 1-32

Abstract: We model an informed agent with information about the future value of an asset trying to maximize profits when the agent’s trades are subjected to a transaction cost as well as a market maker tasked with setting fair transaction prices. In a single auction model, equilibrium is characterized by the unique root of a particular polynomial. Analysis of this polynomial with small levels of risk-aversion and transaction costs reveal a dimensionless parameter which captures several orders of asymptotic accuracy of the equilibrium behavior. In a continuous time analogue of the single auction model, incorporation of a transaction costs allows the informed agent’s optimal trading strategy to be obtained in feedback form. Linear equilibrium is characterized by the unique solution to a system of two ordinary differential equations, of which one is forward in time and one is backward. When transaction costs are in effect, the price set by the market maker in equilibrium is not fully revealing of the informed agent’s private signal, leaving an information gap at the end of the trading interval. When considering vanishing transaction costs, the equilibrium trading strategy and pricing rules converge to their frictionless counterparts.

Keywords: Market microstructure; asymmetric information; price impact; transaction cost (search for similar items in EconPapers)
Date: 2021
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024921500060

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