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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2007/24:
Strategic Insider Trading Equilibrium: A Forward Integration Approach

Knut K. Aase (), Terje Bjuland () and Bernt Øksendal ()

Abstract: The continuous-time version of Kyle’s (1985) model of asset pricing with asymmetric information is studied, and generalized in various directions, i.e., by allowing time-varying noise trading, and by allowing the orders of the noise traders to be correlated with the insider’s signal. From rather simple assumptions we are able to derive the optimal trade for an insider; the trading intensity satisfies a deterministic integral equation, given perfect inside information. We use a new technique called forward integration in order to find the optimal trading strategy. This is an extension of the stochastic integral which takes account of the informational asymmetry inherent in this problem. The market makers’ price response is found by the use of filtering theory. The novelty is our approach, which could be extended in scope.

Keywords: Insider trading; asymmetric information; equilibrium; strategic trade; filtering theory; forward integration; (follow links to similar papers)

JEL-Codes: C00; G12; (follow links to similar papers)

27 pages, November 8, 2007

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