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

39 Pages Posted: 29 Jun 2020 Last revised: 24 Sep 2021

See all articles by Kerry Back

Kerry Back

Rice University - Jesse H. Jones Graduate School of Business

François Cocquemas

Florida State University

Ibrahim Ekren

Florida State University

Abraham Lioui

EDHEC Business School and Scientific Beta Research Chair

Date Written: August 11, 2021

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.

Keywords: Kyle's model, options, informed trading, optimal transport, asymmetric information, price impact, risk aversion

JEL Classification: G12, G13, G14

Suggested Citation

Back, Kerry and Cocquemas, François and Ekren, Ibrahim and Lioui, Abraham, Optimal Transport and Risk Aversion in Kyle's Model of Informed Trading (August 11, 2021). Available at SSRN: https://ssrn.com/abstract=3628726 or http://dx.doi.org/10.2139/ssrn.3628726

Kerry Back

Rice University - Jesse H. Jones Graduate School of Business ( email )

6100 South Main Street
P.O. Box 1892
Houston, TX 77005-1892
United States

François Cocquemas (Contact Author)

Florida State University ( email )

Tallahassee, FL 32306-1042
United States

Ibrahim Ekren

Florida State University ( email )

1017 Academic Way,
224 LOVE Building
Tallahassee, FL 32306
United States
7342741176 (Phone)

Abraham Lioui

EDHEC Business School and Scientific Beta Research Chair ( email )

France

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