Strategic Trading, Information Asymmetry, and Securities Prices

Abstract:     
This paper develops a model of securities markets with a single strategic trader who is potentially better informed than the public. Unlike in the Kyle model (Kyle (1985) and Back (1992)), market makers do not have perfect information about whether the strategic trader is informed. With common prior beliefs, not only do market makers need to update their value estimate as in the Kyle model, but also to update their probability estimate that the strategic trader has private information, based on the observed cumulative order flow. Due to the dynamics of this probability estimate, the resulting equilibrium pricing rule yields richer price dynamics than that in the Kyle model. Some properties of price volatility are discussed in details in an example with a lognormal distribution.

Number of Pages in PDF File: 42

Keywords: Asymmetric Information, Informed Trader, Price Impact, Probability of Informed Trading, Volatility, Zakai Equation

JEL Classification: D82, D83, G14

working papers series