Finance 400

A. Penati - G. Pennacchi
“Market Micro-Structure: Notes on the Kyle Model”
These notes consider the single-period model in Kyle (1985) “Continuous Auctions and In-
sider Trading,” Econometrica 15, p.1315-1335. This model derives equilibrium security prices
when traders have asymmetric information. Equilibrium prices partially reflect inside informa-
tion. The model assumes three types of agents in a market for a particular security: a market
maker (such as a stock exchange specialist or security dealer); a “noise” trader; and an insider.
It provides a theoretical framework for determining bid-ask spreads and the “market impact”
of trades.
I. Assumptions:
A.1) The model is a single period model. At the beginning of the period, agents trade in an
asset that has a random end of period liquidation value of ν̃ ∼ N (p0 , Σ0 ).
A.2) Noise traders have needs to trade that are exogenous to the model. It is simply assumed


that they, as a group, submit a “market” order to buy ũ shares of the asset, where ũ ∼ N 0, σu2 .
ũ and ν̃ are assumed to be independently distributed.1
A.3) The single risk-neutral insider is assumed have better information than the other agents.
He knows with perfect certainty the realized end of period value of the risky security ν̃ (but not
ũ) and chooses to submit a market order of size x that maximizes his expected end of period
profits.2
A.4) The single risk-neutral market maker (for example, the specialist) receives the market
orders submitted by the noise traders and the insider, which in total equal u + x. Importantly,
the market maker cannot distinguish what part of this total order consists of orders made by
noise traders and what part consists of the order of the insider. (The traders are anonymous.)
1
Why rational noise traders submit these orders has been modeled by assuming they have exogenous “shocks”
to their wealth and need to rebalance their portfolio (M. Spiegel and A. Subrahmanyam (1992) “Informed
Speculation and Hedging in a Noncompetitive Securities Market,” Review of Financial Studies 5, p.307-329) or
by assuming that they have uncertainty regarding the timing of their consumption (G. Gorton and G. Pennacchi
(1993) “Security Baskets and Index-Linked Securities,” Journal of Business 66, p.1-27).
2
This assumption can be weakened to the case of the insider having uncertainty over ν̃ but having more
information on ν̃ than the other traders. One can also allow the insider to submit “limit” orders, that is, orders
that are a function of the equilibrium market price (a demand schedule), as in Kyle (1989) “Informed Speculation
with Imperfect Competition,” Review of Economic Studies 56, p.317-56.
1
The market maker sets the market price, p, and then takes the position − (u + x) to clear the
market. It is assumed that market making is a perfectly competitive profession, so that the
market maker sets the price p such that, given the total order submitted, his profit at the end
of the period is expected to be zero.
II. Analysis:
Since the noise traders’ order is exogenous, we need only to consider the optimal actions of
the market maker and the insider.
The market maker observes only the total order flow, u + x. Given this information, he
must then set the equilibrium market price p that gives him zero expected profits. Since his
end of period profits are − (ν̃ − p) (u + x), this implies that the price set by the market maker
satisfies

p = E [ν̃ | u + x] (1)
The information on the total order size is important to the market maker. The greater the total
order size, the more likely it is that x is large because the insider knows ν is greater than p0.
Thus, the market maker would tend to set p higher than otherwise. Similarly, if u + x is low,
the more likely it is that x is low because the insider knows ν is below p0 and is submitting a
sell order. In this case, the market maker would tend to set p lower than otherwise. Thus, the
pricing rule of the market maker is a function of x + u, that is, P (x + u).

Since the insider sets x, it is an endogenous variable that depends on ν̃. The insider chooses
x to maximize his expected end of period profits, π̃ , given knowledge of ν and the way that the
market maker behaves in setting the equilibrium price:

max
x
E [π̃ | ν ] =max
x
E [(ν − P (x + ũ)) x | ν ] (2)
An equilibrium in this model is a pricing rule chosen by the market maker and a trading
strategy chosen by the insider such that: the insider maximizes expected profits, given the
market maker’s pricing rule; the market maker sets the price to earn zero expected profits, given
the trading strategy of the insider; the insider and market maker have rational expectations,
that is, the equilibrium is a fixed-point where an agent’s actual behavior is that expected by

2
the other.
Suppose the market maker chooses a market price that is a linear function of the total order
flow, P (y) = µ + λy. We will later argue that a linear pricing rule is optimal. If this is so, what
is the insider’s choice of x? From (2) we have

max
x
E [(ν − P (x + ũ)) x | ν ] = max
x
E [(ν − µ − λ (x + ũ)) x | ν ] (3)
= max
x
(ν − µ − λx) x, since E [ũ] = 0

Thus, the solution to the insider’s problem in (3) is

x = α + βν (4)
where α = − 2µλ and β = 21λ . Therefore, if the market maker uses a linear pricing-setting rule,
the optimal trading strategy for the insider is a linear trading rule.
Next, let us return to the market maker’s problem of choosing the market price that, condi-
tional on knowing the total order flow, results in a competitive (zero) expected profit. Given the
assumption that market making is a perfectly competitive profession, a market maker needs to
choose the “best” possible estimate of E [ν̃ u + x] in setting the price p = E [ν̃ u + x]. What
| |

estimate of the mean of ν is best? The maximum likelihood estimate of E [ν̃ u + x] is best
|

in the sense that it attains maximum efficiency and is also the minimum variance unbiased
estimate.
Note that if the insider follows the optimal trading strategy, which according to equation
(4) is x = α + β ν̃, then from the point of view of the market maker, ν̃ and y ũ + x = ũ + α + β ν̃
≡

are jointly normally distributed. Because ν and y are jointly normal, the maximum likelihood
estimate of the mean of ν conditional on y is linear in y, that is, E [ν̃ y] is linear in y when
|

they are jointly normally distributed. Hence, the previously assumed linear pricing rule is, in
fact, optimal in equilibrium. Therefore, the market maker should use the maximum likelihood
estimator, which in the case of ν and y being normally distributed is equivalent to the “least
squares” estimator. This is the one that minimizes

3
    
E (ν̃ − P (y))2 = E (ν̃ − µ − λy)2 (5)
 
= E (ν̃ − µ − λ (ũ + α + β ν̃ ))2

Thus, the optimal pricing rule equals µ + λy where µ and λ minimize

 
min E (ν̃ (1 − λβ ) − λũ − µ − λα)2 (6)
µ,λ
   
Recalling the assumptions E [ν ] = p0, E (ν − p0)2 = Σ0 , E [u] = 0, E u2 = σu2 , and E [uν] =
0, the above objective function can be written as

 
min (1 − λβ)2 Σ0 + p20
2
+ (µ + λα) + λ2 σu2 − 2 (µ + λα) (1 − λβ ) p0 (7)
µ,λ

The first order conditions with respect to µ and λ are

µ = −λα + p0 (1 − λβ ) (8a)

 
−2β (1 − λβ) Σ0 + p20 + 2α (µ + λα) + 2λσu2 − 2p0 [−β (µ + λα) + α (1 − λβ)] = 0 (8b)

Substituting µ + λα = p0 (1 − λβ ) from (8a) into (8b), we see that (8b) simplifies to

β Σ0
λ= (8b)
β 2 Σ0 + σu2
Substituting in for the definitions α = − 2µλ and β = 1
2λ in (8a) and (8b), we have3

µ = p0 (9a)

√Σ
1 0
λ= 2 (9b)
σu

3
Note the typo in the solution for in Theorem 1 of the Kyle paper.

4
 In summary, the equilibrium price is
√Σ
1 0
p = p0 + 2 (ũ + x̃) (10)
σu

where the equilibrium order submitted by the insider is

x= √σΣu (ν̃ − p0 ) (11)

0

From (11), we see that the greater is the volatility (amount) of noise trading, σu , the
larger is the magnitude of the order submitted by the insider for a given deviation of ν from
its unconditional mean. Hence, the insider trades more actively on his private information
the greater is the “camouflage” provided by noise trading. More noise trading makes it more
difficult for the market maker to extract the “signal” of insider trading from the noise. Note
that if equation (11) is substituted into (10), one obtains

√Σ
ũ + 12 (ν̃ − p0 )
1 0
p = p0 + 2 (12)
σu
√Σ
ũ + p0 + ν̃
1 0
= 2 σu

Thus we see that only one-half of the insider’s private information, 12 ν̃, is reflected in
the equilibrium price, so that the price is not fully revealing. (A fully-revealing price would
be p = ν̃ .) To obtain an equilibrium of incomplete revelation of private information, it was
necessary to have a second source of uncertainty, namely, the amount of noise trading.
Using (11) and (12), we can calculate the insider’s expected profits:

σu
√Σ
E [π̃] = E [x (ν − p)] = E √Σ (ν̃ − p0 ) 12 ν − p0 −
σu
0
ũ (13)
0

Conditional on knowing ν, that is, after learning the realization of ν at the beginning of the
period, the insider expects profits of

E [π̃ | ν] = 1
2
√σΣu (ν − p0)2 (14)
0

5
Hence, the larger is ν ’s deviation from p0 , the larger the expected profit. Unconditional on
knowing ν̃ , that is, before the start of the period, the insider expects a profit of

 
E [π̃ ] = 1
2 √σΣu E (ν̃ − p0)2 = 12 σu Σ0 (15)
0

which is proportional to the standard deviations of noise traders’ order and the end of period
value of ν .
Since, by assumption, the market maker sets the security price in a way that gives him
zero expected profits, the expected profits of the insider equals the expected losses of the noise
traders. In other words, it is the noise traders, not the market maker, that lose, on average,
from the presence of the insider.
√
1 Σ0
From equation (10), we see that λ = 2 σu is the amount that the market maker raises the
price when the total order flow, (u + x), goes up by 1 unit. Hence, the amount of order flow
necessary to raise the price by $1 equals 1/λ = 2 √σΣu0 , which is a measure of the “depth” of
the market or market “liquidity.” The higher is the proportion of noise trading to the value of
insider information, √σΣu0 , the deeper or more liquid is the market. Intuitively, the more noise
traders relative to the value of insider information, the less the market maker needs to adjust
the price in response to a given order, since the likelihood of the order being that of a noise
trader, rather than an insider, is greater. While the greater is the number of noise traders (that
is, the greater is σu ), the greater is the profits of the insider (see equation 15) and the greater is
the total losses of the noise traders. However, an individual noise trader’s expected loss is less.4

4
See G. Gorton and G. Pennacchi (1993) “Security Baskets and Index-Linked Securities,” Journal of Business
66 p.1-27 for an explicit derivation of this result.