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Insider Trading with Temporary Price Impact

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  • Weston Barger
  • Ryan Donnelly

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.

Suggested Citation

  • Weston Barger & Ryan Donnelly, 2020. "Insider Trading with Temporary Price Impact," Papers 2007.14162, arXiv.org.
    • Handle: RePEc:arx:papers:2007.14162
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    References listed on IDEAS

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    1. Johannes Muhle-Karbe & Max Reppen & H. Mete Soner, 2016. "A Primer on Portfolio Choice with Small Transaction Costs," Papers 1612.01302, arXiv.org, revised May 2017.
    2. Baruch, Shmuel, 2002. "Insider trading and risk aversion," Journal of Financial Markets, Elsevier, vol. 5(4), pages 451-464, October.
    3. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    4. Magill, Michael J. P. & Constantinides, George M., 1976. "Portfolio selection with transactions costs," Journal of Economic Theory, Elsevier, vol. 13(2), pages 245-263, October.
    5. Holden, Craig W. & Subrahmanyam, Avanidhar, 1994. "Risk aversion, imperfect competition, and long-lived information," Economics Letters, Elsevier, vol. 44(1-2), pages 181-190.
    6. M. H. A. Davis & A. R. Norman, 1990. "Portfolio Selection with Transaction Costs," Mathematics of Operations Research, INFORMS, vol. 15(4), pages 676-713, November.
    7. Back, Kerry, 1992. "Insider Trading in Continuous Time," The Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 387-409.
    8. Subrahmanyam, Avanidhar, 1998. "Transaction Taxes and Financial Market Equilibrium," The Journal of Business, University of Chicago Press, vol. 71(1), pages 81-118, January.
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    Cited by:

    1. Jin Hyuk Choi & Heeyoung Kwon & Kasper Larsen, 2022. "Trading constraints in continuous-time Kyle models," Papers 2206.08117, arXiv.org.

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