Insider Trading with Temporary Price Impact

35 Pages Posted: 5 Sep 2020

See all articles by Weston Barger

Weston Barger

University of Washington

Ryan Francis Donnelly

King's College London

Date Written: July 28, 2020

Abstract

We model an informed agent with information about the future value of an asset trying to maximize profits when 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 behaviour. 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

JEL Classification: C73, G14, C61

Suggested Citation

Barger, Weston and Donnelly, Ryan Francis, Insider Trading with Temporary Price Impact (July 28, 2020). Available at SSRN: https://ssrn.com/abstract=3662341 or http://dx.doi.org/10.2139/ssrn.3662341

Weston Barger

University of Washington ( email )

Seattle, WA 98195
United States

Ryan Francis Donnelly (Contact Author)

King's College London ( email )

Strand
London, England WC2R 2LS
United Kingdom

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