Insider Trading with Uncertain Informed Trading

42 Pages Posted: 21 Nov 2006 Last revised: 8 Nov 2013

Tao Li

City University of Hong Kong (CityUHK) - Department of Economics & Finance

Date Written: February 2, 2013

Abstract

This paper develops a model of securities market with a 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 they also have to update their estimate of the probability that the strategic trader has private information based on the observed cumulative order flow. The dynamics of this probability estimate causes the pricing rule to be stochastic, and so do the market depth and price volatility. The expected profit of the strategic trader is lower with lower prior probability that she is informed, thus, the model is robust.

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

JEL Classification: D82, D83, G14

Suggested Citation

Li, Tao, Insider Trading with Uncertain Informed Trading (February 2, 2013). Available at SSRN: https://ssrn.com/abstract=946324 or http://dx.doi.org/10.2139/ssrn.946324

Tao Li (Contact Author)

City University of Hong Kong (CityUHK) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

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