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4.7 Exercises
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4. Variance of price change and average pricing error in Kyle’s model.
Consider the static model by Kyle (1985), where (i) market makers are risk neutral
and perfectly competitive, (ii) the asset value is v ∼ N (µ, σ 2v ), (iii) the informed
investor’s order is x = β(v − µ), and the noise traders’ order is u ∼ N (0, σ 2u ); and
(iv) market makers only observe the total net order q = x + u.
σ 2u
var(v − p) = 2 2 2
σ 2v ,
β σv + σu
β 2 σ 2v
var(p − µ) = 2 2 σ 2v .
β σ v + σ 2u
4.8 Solutions
Exercise 2:
a. Simply replace σ 2u = σ 2u1 + σ 2u2 in the optimal strategies of the market makers
and of the informed trader computed in Kyle’s model:
βσ 2v 1
(i) p = µ + 2 2 q, (ii) x = (v − µ),
β σ v + σ 2u1 + σ 2u2 2λ
3
p
σv σ 2u1 + σ 2u2
(iii) λ∗ = p 2 , β∗ = .
2
2 σ u1 + σ u2 σv
b. If market makers are able to observe the actual realization of the order u1
placed by group 1 before trading, this is no longer an uncertain variable from their
viewpoint. Hence the solution to their updating problem is simply found by replacing
σ 2u = σ 2u2 in the optimal strategies of the market makers computed in Kyle’s model:
βσ 2v 1
(i) p = µ + 2 2 2
q, (ii) x = (v − µ),
β σ v + σ u2 2λ
σv σ u2
(iii) λ∗∗ = , β ∗∗ = .
2σ u2 σv
c. If we compare the answers to point (i) under (a) and (b), we see that in
solving their inference problem now market makers assign a greater weight to the
order flow. Intuitively, the informational value of an order is now greater because
market makers face less true noise: since from their viewpoint is no longer stochastic,
σ 2v σ 2v
the signal-noise ratio drops from σ 2u1 +σ 2u2
to σ 2u2
. Hence, they e§ectively face more
adverse selection, and accordingly o§er less depth: λ∗∗ > λ∗ . In response to this
decrease in market depth, in equilibrium the insider chooses a less aggressive trading
strategy: β ∗∗ < β ∗ , since he faces higher trading costs.
Exercise 4:
βσ 2v
a. Since p = E[v|q] = µ + λq, where λ is given by β 2 σ 2v +σ 2u
, we can express v − p
as follows:
v − p = v − µ − λq = v − µ − λ(x + u) =
= v − µ − λ[β(v − µ) + u] = (1 − λβ)(v − µ) − λu
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so that:
p − µ = µ + λq − µ = λq = λ(x + u) =
= λ[β(v − µ) + u]
so that:
# $
var(p − µ) = var[λ[β(v − µ) + u]] = λ2 β 2 σ 2v + σ 2u =
! "2
βσ 2v # 2 2 2
$
= 2 2 β σ v + σ u =
β σ v + σ 2u
β 2 σ 4v
= 2 2
β σ v + σ 2u
This expression is increasing in the informed traders’ aggressiveness β:
% & # $
@ β 2 σ 4v 2βσ 4v β 2 σ 2v + σ 2u − 2βσ 2v β 2 σ 4v
= # 2 $2 =
@β β 2 σ 2v + σ 2u β σ 2v + σ 2u
β 3 σ 6v + βσ 4v σ 2u − β 3 σ 6v βσ 4v σ 2u
=2 # 2 $2 = 2# 2 $2 > 0
β σ 2v + σ 2u β σ 2v + σ 2u
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The intuitive reason for this result is that more aggressive trading by informed
investors makes orders more informative, and therefore moves prices by more: hence,
trading raises volatility.