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Optimal Transport and Risk Aversion in Kyle's Model of Informed Trading

Kerry Back, Francois Cocquemas, Ibrahim Ekren and Abraham Lioui

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Abstract: We establish connections between optimal transport theory and the dynamic version of the Kyle model, including new characterizations of informed trading profits via conjugate duality and Monge-Kantorovich duality. We use these connections to extend the model to multiple assets, general distributions, and risk-averse market makers. With risk-averse market makers, liquidity is lower, assets exhibit short-term reversals, and risk premia depend on market maker inventories, which are mean reverting. We illustrate the model by showing that implied volatilities predict stock returns when there is informed trading in stocks and options and market makers are risk averse.

Date: 2020-06, Revised 2021-08
New Economics Papers: this item is included in nep-mst
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