Chapter 4

Trade Size and Market Depth

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4.7 Exercises

2. Noise trading in Kyles model. Consider the model presented in section

4.2 (Kyle, 1985), changing only the assumption about noise trading: assume that
there are two groups (1 and 2) of noise traders, whose orders are respectively u1
N (0, 2u1 ) and u2 N (0, 2u2 ), both uncorrelated with the assets future value (i.e.
cov(v, u1 ) = cov(v, u2 ) = 0). All the other assumptions of the model are unchanged:
(i) market makers are risk neutral and perfectly competitive, (ii) the asset value is
v N (, 2v ), (iii) the informed investors order is x = (v ), and (iv) market
makers only observe the total net order q = x + u1 + u2 . [Hint: think whether your
answers require computing the results of the Kyle model again.]

a. Derive (i) the price schedule p = + q chosen by competitive market makers,

under the assumption that the informed traders order is x = (v ); (ii) the
optimal informed traders order, given the price schedule chosen by market makers;
and (iii) the equilibrium values of and .
b. Now suppose that market makers can observe the actual realization of the
order placed by group 1 (for instance, because these are local investors, while those of
group 2 are foreign investors) before trading occurs. Under this further assumption,
derive again (i) the price schedule p = + q chosen by competitive market makers,
under the assumption that the informed traders order is x = (v ); (ii) the
optimal informed traders order, given the price schedule chosen by market makers;
and (iii) the equilibrium values of and .
c. Compare the results obtained under (a) and under (b): does the assump-
tion made under (b) change the equilibrium market depth and informed traders
aggressiveness and, if so, what is the intuitive reason for this dierence?

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4. Variance of price change and average pricing error in Kyles 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 (, 2v ), (iii) the informed
investors order is x = (v ), and the noise traders order is u N (0, 2u ); and
(iv) market makers only observe the total net order q = x + u.

a. Based on the price schedule p = + q chosen by competitive market makers

in this model, show that the variance of price changes is:

2u
var(v p) = 2 2 2
2v ,
v + u

and explain intuitively why it is decreasing in the informed traders aggressiveness

.
b. Show that the average pricing error is:

2 2v
var(p ) = 2 2 2v .
v + 2u

Is this expression increasing or decreasing in informed traders aggressiveness ?

Explain intuitively why.

4.8 Solutions

Exercise 2:
a. Simply replace 2u = 2u1 + 2u2 in the optimal strategies of the market makers
and of the informed trader computed in Kyles model:

2v 1
(i) p = + 2 2 q, (ii) x = (v ),
v + 2u1 + 2u2 2

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 p
v 2u1 + 2u2
(iii) = p 2 , = .
2
2 u1 + u2 v

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
2u = 2u2 in the optimal strategies of the market makers computed in Kyles model:

2v 1
(i) p = + 2 2 2
q, (ii) x = (v ),
v + u2 2

v u2
(iii) = , = .
2 u2 v

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,
2v 2v
the signal-noise ratio drops from 2u1 + 2u2
to 2u2
. Hence, they eectively face more
adverse selection, and accordingly oer less depth: > . In response to this
decrease in market depth, in equilibrium the insider chooses a less aggressive trading
strategy: < , since he faces higher trading costs.

Exercise 4:
2v
a. Since p = E[v|q] = + q, where is given by 2 2v + 2u
, we can express v p
as follows:

v p = v q = v (x + u) =

= v [(v ) + u] = (1 )(v ) u

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 so that:

var(v p) = var[(1 )(v ) u] = (1 )2 2v + 2 2u =

! "2 ! "2
2v 2 2v
= 1 2 2 2
v + 2 2 2
2u =
v + u v + u
! " 2 ! "2
2u 2 2v
= v + 2u =
2 2v + 2u 2 2v + 2u
4 2 + 2 4v 2u 2 2v + 2u 2 2 2u 2v
= #u 2v $2 = # 2
$2 u v =
2v + 2u 2v + 2u 2 2v + 2u
The intuitive reason why this expression is decreasing in the informed traders
aggressiveness is that more aggressive trading by them makes the price closer to
fundamentals, hence it reduces pricing error and leads to better price discovery.
b. Since p =E[v|q] = + q, we can write:

p = + q = q = (x + u) =

= [(v ) + u]

so that:
# $
var(p ) = var[[(v ) + u]] = 2 2 2v + 2u =
! "2
2v # 2 2 2
$
= 2 2 v + u =
v + 2u
2 4v
= 2 2
v + 2u
This expression is increasing in the informed traders aggressiveness :
% & # $
@ 2 4v 2 4v 2 2v + 2u 2 2v 2 4v
= # 2 $2 =
@ 2 2v + 2u 2v + 2u

3 6v + 4v 2u 3 6v 4v 2u
=2 # 2 $2 = 2# 2 $2 > 0
2v + 2u 2v + 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.