NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Insider Trading, Stochastic Liquidity and Equilibrium Prices

Pierre Collin-Dufresne, Vyacheslav Fos

NBER Working Paper No. 18451
Issued in October 2012
NBER Program(s):   AP   CF   EFG

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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Document Object Identifier (DOI): 10.3386/w18451

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