Continuous Auctions and Insider Trading

A. Kyle, Econometrica, 1985

Andrea Gallo

School of Economics and Finance

Queen Mary University of London

Topics in Financial Economics A, 2020

Andrea Gallo Continuous Auctions and Insider Trading

Introduction and Motivation

How quickly is private information incorporated into market

prices?

How valuable is private information to an insider?

How does noise trading affect price volatility?

What determine the liquidity of a speculative market?

This paper shows how we can address this kind of

questions by modelling the trading strategy of and insider
in a dynamic model of efficient price formation

Andrea Gallo Continuous Auctions and Insider Trading

Introduction and Motivation
Focus on Market Liquidity

How can we define market liquidity? It’s an elusive concept

Intuitively, it has something to do with the smoothness of

transactions. But can we say something more precise?

Kyle refers to Black’s definition of liquid market as a

continuous and efficient market:
1 Almost any amount of stock can be bought and sold
immediately

2 Small amount of stocks can be traded near the market price

at any moment, and large amount of stocks can be traded
on average near the market price in the long run

Andrea Gallo Continuous Auctions and Insider Trading

Overview of the Model
The Players

One risky asset exchanged for a risk-free asset among

three kind of traders:

1 A single insider with private information on the ex-post

liquidation value of the asset

2 Uninformed noise traders who trade randomly

3 Market makers setting prices efficiently (semi-strong

sense) observing quantities traded by others

Trading is modelled as a sequence of many auctions, with

a strong emphases on dynamic optimizing behavior

Andrea Gallo Continuous Auctions and Insider Trading

Overview of the Model
Strategic Interaction and Information

At each auction trading takes place in two stages

In the first one, the insider and the noise traders choose
the quantity to trade. She privately observes the liquidation
value of the asset and what she learned and chosen
previously in the game

In the second stage, the market makers set a price choose

quantity to trade so that the markets clear. They observe
current and past aggregate quantities traded. They do not
observe individual quantities traded

Key feature: the informed trader is not price taker!

Andrea Gallo Continuous Auctions and Insider Trading

Overview of the Results

Studying this model in discrete and continuous time, the

paper addresses the questions posed at the beginning

In particular, the informed trader trades so that her private

information is gradually incorporated into prices

In the continuous model it is shown that all the private

information is incorporated by the end of the trading
process

Comparative statics: an ex-ante doubling of quantities

traded by noise traders has no effect on prices and
doubles the profits of the insider

Andrea Gallo Continuous Auctions and Insider Trading

Overview of the Results
Focus on Market Liquidity

The continuous auction equilibrium characterized in the

paper describes a liquid market in the sense of Black

Moreover, the presence of a non price-taking agent makes

market depth and resiliency endogenous variables of this
model

In particular, depth is proportional to noise trading volume

and inversely proportional to private information not
incorporated into market prices

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Preliminaries and Notation

We now consider a model of one-shot trading (only one

auction)

The liquidation value of the risky asset is ve ∼ N(p0 , Σ0 )

e ∼ N(0, σu2 ) and it

The quantity traded by noise traders is u
is independent from ve.

e.
The insider trades a quantity xe and the price is p

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
The Game 1/2

First, the insider chooses the quantity xe while observing ve

(but not ue).

Insider’s trading strategy: It’s a function X that assigns

to each realization of ve a quantity traded, denoted as xe

Then, market makers observe xe + u

e but not xe, u
e and ve
separately

Market makers’ pricing rule: It’s a function P that

assigns, for each observed xe + u e
e a price p

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
The Game 2/2

e)xe
e = (ve − p
Insider’s profit function: π
Definition of Equilibrium: An equilibrium of this game is
a pair (X , P) such that the following two conditions hold:

1 Profit Maximization:
π (X 0 , P)|ve = v }
π (X , P)|ve = v } ≥ E{e
E{e

2 e(X , P) = E{ve|xe + u
Market Efficiency: p e}

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Characterization of the Equilibrium (theorem)

Theorem 1: There exist a unique equilibrium couple (X , P) in

which X and P are linear functions. If
 1/2  −1/2
β = σu2 /Σ0 and λ = 2 σu2 /Σ0 ,

then

X (ve) = β(ve − p0 ), P(xe + u

e) = p0 + λ(xe + u
e)

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Characterization of the Equilibrium (proof 1/2)

Suppose that for constants μ, λ, α, β, linear functions P and X

are given by

P(y) = μ + λy, X (v ) = α + βv
Given the linear rule P, profits can be written

E{[ve − P(x + u
e)]x|ve = v } = (v − μ − λx)x
Profit maximization of this quadratic objective requires that x
solve v − μ − 2λx = 0. We thus have X (v ) = α + βv with

1
= 2λ, α = −μβ
β

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Characterization of the Equilibrium (proof 2/2)

Given linear X and P, the market efficiency condition is

equivalent to

μ + λy = E{ve|α + β ve + u
e = y}

Normality makes the regression linear and application of the

projection theorem yields

βΣ0
λ= 2
, μ − p0 = −λ(α + βp0 )
β2Σ 0 + σu

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Properties of the Equilibrium 1/2

In equilibrium (X , P) is determined by the exogenous

parameters Σ0 and σu2 .
To compute a measure of informativeness of prices, let Σ1
e. Then, Σ1 = 0.5Σ0
be the variance of ve given p
=⇒ Half of the insider’s private information is incorporated
into prices and the volatility is unaffected by noise trading

Andrea Gallo Continuous Auctions and Insider Trading

Single Auction Equilibrium
Properties of the Equilibrium 2/2

1/μ is a measure of market depth, i.e. the order flow

necessary to induce prices to change by one dollar
It is proportional to a ratio of noise trading over private
information
Intuition: Market makers compensate themselves for bad
trades due to asymmetric information by making the
market less liquid
Moreover, maximized profits v 2 /4μ are proportional to the
depth of the market: if the insider can trade more without
affecting prices, she will make more profits

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
The game 1/3

Consider a generalization of the previous model: a number

of auctions takes place sequentially
In particular, we have N auctions. The nth auction takes
place at tn . The sequence of auction dates is s.t. t0 = 0
and t1 =1.
Let u e(t) be a Brownian motion with instantaneous variance
σu2 .
Since Brownian motion, the quantity traded is
Δuen ∼ N(0, σu2 )Δtn , and it is independent on the quantity
traded at other auctions

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
The game 2/3

The liquidation value of the asset ve ∼ N(p0 , Σ0 ) is

independent from the Brownian motion process

The N auctions take place sequentially and Δxen is the

quantity traded by the insider at the nth auction, where the
en .
market clearing price is p

At each auction information sets are modified to take into

account past information; in particular, the insider observes
the liquidation value and past prices, whereas market
makers observe past and present order flows

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
The game 3/3

For this game, the trading strategy X becomes a vector

specifying a quantity at each auction, and the pricing rule
P a vector specifying a price at each auction
The profit for the insider on position acquired at n is
en = Σn (ve − p
π ek )xek
We want to stress that prices, quantities and profit at
period n are a function of the trading and pricing strategies,
so they depend on the strategy profile (X , P)

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Equilibrium of the Game 1/2

Equilibrium: We say that a strategy profile (X , P) is a

sequential auction equilibrium if the following two
conditions hold:
1 Profit Maximization:

e1 , . . . , p
πn (X , P)|p
E{e πn (X 0 , P)|p
en−1 , ve} ≥ E{e e1 , . . . , p
en−1 , ve}

2 en = E{ve|xe1 + u
Market Efficiency: p e1 , . . . , xen + u
en }

Linear Equilibrium: It’s an equilibrium of this game such

that the components of (X , P) are linear. A recursive
linear equilibrium is a linear equilibrium in which that
there exist constants λ1 , ..., λN such that for n = 1, ..., N we
have pen = pen−1 + λn (Δxen + Δu en )

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Equilibrium of the Game 2/2

Note that the market efficiency condition implies that prices

follow a martingale whose pattern of volatility reflects the
rate at which information is incorporated into prices
In a linear equilibrium price increments are normally and
independently distributed with zero mean
=⇒ The distribution of the pricing process is characterized
by a sequence of variance parameters measuring volatility
of prices from auction to auction
The profit maximization condition is such that the quantity
chosen at n maximizes expected payoff over the remaining
stages given information at each information set
=⇒ Sequential rationality given beliefs consistent with
Bayesian updating, like in Kreps and Wilson sequential
equilibrium

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Characterization of the equilibrium 1/2

Theorem 2: There exists a unique linear equilibrium and this

equilibrium is a recursive linear equilibrium. In this equilibrium
there are constants βn , λn , αn , δn and Σn such that for
en−1 )Δtn
Δxen = βn (ve − p
Δpen = λn (Δxen + Δuen )
Σn = var (ve|Δxe1 + Δu
e1 , . . . , Δxen + Δu
en )
πn |p1 , . . . , pn1 , v } = αn−1 (v − pn−1 )2 + δn−1
E{e

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Characterization of the Equilibrium 2/2

Given Σ0 the constants βn , λn , αn , δn , Σn are the unique

solution to the difference equation system
1
αn−1 = 4λn (1−αn λn )
δn−1 = δn + αn λ2n σu2 Δtn
n λn
βn Δtn = 2λ1−2α
n (1−αn λn )

λn = βn Σn /σu2
Σn = (1 − βn λn Δtn )Σn−1
subject to αN = δN = 0 and the second order condition

λn (1 − αn λn ) > 0

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Providing some Intuition

B.I. argument to obtain X . The insider has to decide how

much to trade on the basis of private information, past
market depth and her expectation on future market depth.

If market depth is going to increase, the insider has an

incentive to save private information by trading small
quantities now and large quantities later

Conversely, if market depth is going to decrease, the

insider is better off by trading more today, where profits are
greater

Andrea Gallo Continuous Auctions and Insider Trading

Sequential Auction Equilibrium
Properties of the Equilibrium

As before, information is gradually incorporated into prices

(ΣN , the informativeness of prices, declines monotonically)

From the difference equations system we see that as noise

(variance) increases, market depth and insider’s profits
increase proportionally, leaving the informativeness of
prices unchanged

Moreover, the proof shows that as prior private information

1/2
(Σ0 ) increase, expected ex ante profits increase, as in
the single auction model

Andrea Gallo Continuous Auctions and Insider Trading

Continuous Auction Equilibrium

The author also discusses a model in which trades take

place continuously rather than at discrete intervals
He shows that the sequential auction equilibrium
discussed before converges to the continuous auction
equilibrium when auctions are held frequently enough
The main result of the continuous model is that the depth
of the market is constant over time and that the volatility of
prices is constant
This implies that not only information is incorporated into
prices gradually, but also that this happens at a constant
rate
As before, insider’s ex ante profits are directly proportional
to prior private information

Andrea Gallo Continuous Auctions and Insider Trading

Continuous Auction vs Sequential Auction Equilibrium
Market Liquidity 1/2

Tightness, a measure of costly of turning over a position

in a short period of time, is infinite in the continuous model,
in the sense that it is costless to turn over very quickly.
This happens because auctions are held frequently
enough, so that the insider can trade at any price along the
supply curve but it is not true in the discrete model
Depth, the ability of the market to absorb quantities
without affecting prices too much is constant in the
continuous model (in equilibrium), differently from the
sequential model
Intuition: the insider in equilibrium reacts to depth adjusting
her trading volumes accordingly. If depth increases, the
insider wants to destabilize prices before the increase to
generate unbounded profits; if depth decreases she wants
to incorporate immediately her private information into
prices
Andrea Gallo Continuous Auctions and Insider Trading
Continuous Auction vs Sequential Auction Equilibrium
Market Liquidity 2/2

Resiliency refers to the speed with which prices converge

to the true liquidation value of assets, and thus measures
also the rate at which prices bounce back after
uninformative shocks

In both the sequential and continuous model, resiliency is

determined by the trading volume of the insider

In the continuous model the function characterizing the

trading strategy, β(t), is increasing in time, thus showing
that resiliency grows auction after auction

At the limit, when t approaches the last period, β goes to

infinite, and thus the market becomes infinitely resilient
toward the end of trading
Andrea Gallo Continuous Auctions and Insider Trading
Conclusions

This paper shows how we can model prices as a function

of private information in a sequential strategic setting

Moreover, it shows that the fact that an agent with private

information is not price taker is not inconsistent with market
makers setting efficient prices in the semi strong sense

Lastly, it explains how a discrete model of sequential

trading converges to a continuous model when trading is
held frequently enough

Andrea Gallo Continuous Auctions and Insider Trading