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Insider Trading, Stochastic Liquidity and Equilibrium Prices

  • Pierre Collin-Dufresne
  • Vyacheslav Fos
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    We extend Kyle's (1985) model of insider trading to the case where liquidity provided by noise traders follows a general stochastic process. Even though the level of noise trading volatility is observable, in equilibrium, measured price impact is stochastic. If noise trading volatility is mean-reverting, then the equilibrium price follows a multivariate 'stochastic bridge' process, which displays stochastic volatility. This is because insiders choose to optimally wait to trade more aggressively when noise trading activity is higher. In equilibrium, market makers anticipate this, and adjust prices accordingly. More private information is revealed when volatility is higher. In time series, insiders trade more aggressively, when measured price impact is lower. Therefore, execution costs to uninformed traders can be higher when price impact is lower.

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    File URL: http://www.nber.org/papers/w18451.pdf
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    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18451.

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    Date of creation: Oct 2012
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    Handle: RePEc:nbr:nberwo:18451
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    1. Madhavan, Ananth & Richardson, Matthew & Roomans, Mark, 1997. "Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks," Review of Financial Studies, Society for Financial Studies, vol. 10(4), pages 1035-64.
    2. Kerry Back & Hal Pedersen, 1995. "Long-Lived Information and Intraday Patterns," Finance 9507009, EconWPA.
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    6. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 3-40.
    7. Albert S. Kyle & Jean-Luc Vila, 1991. "Noise Trading and Takeovers," RAND Journal of Economics, The RAND Corporation, vol. 22(1), pages 54-71, Spring.
    8. Baruch, Shmuel, 2002. "Insider trading and risk aversion," Journal of Financial Markets, Elsevier, vol. 5(4), pages 451-464, October.
    9. Foster, F Douglas & Viswanathan, S, 1990. "A Theory of the Interday Variations in Volume, Variance, and Trading Costs in Securities Markets," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 593-624.
    10. Back, Kerry, 1992. "Insider Trading in Continuous Time," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 387-409.
    11. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, number 9780198296980, May.
    12. Foster, F Douglas & Viswanathan, S, 1993. " Variations in Trading Volume, Return Volatility, and Trading Costs: Evidence on Recent Price Formation Models," Journal of Finance, American Finance Association, vol. 48(1), pages 187-211, March.
    13. Masahiro Watanabe, 2008. "Price Volatility and Investor Behavior in an Overlapping Generations Model with Information Asymmetry," Journal of Finance, American Finance Association, vol. 63(1), pages 229-272, 02.
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