Insider Trading, Stochastic Liquidity and Equilibrium Prices
51 Pages Posted: 17 Mar 2012 Last revised: 24 Feb 2016
Date Written: January 26, 2016
We extend Kyle's (1985) model of insider trading to the case where noise trading volatility follows a general stochastic process. We determine conditions under which, in equilibrium, price impact and price volatility are both stochastic, driven by shocks to uninformed volume even though the fundamental value is constant. The volatility of price volatility appears 'excessive' because insiders choose to trade more aggressively (and thus more information is revealed) when uninformed volume is higher and price impact is lower. This generates a positive relation between price volatility and trading volume giving rise to an endogenous subordinate stochastic process for prices.
Keywords: Kyle model, insider trading, asymmetric information, liquidity, price impact, market depth, stochastic volatility, volume, subordinate process, execution costs, continuous time
JEL Classification: G14
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