Stock market dynamics with rational liquidity traders

In the Kyle (1985) finite horizon model of stock market dynamics with a trader who holds long-lived information, informed trading intensities rise with time, and the slopes of the equilibrium price schedules fall. This paper shows that this result depends crucially on the irrational liquidity trader assumption. We replace the irrational noise traders with a sequence of rational, risk averse, liquidity traders who receive endowment shocks to their holdings of the risky asset. We demonstrate that unless liquidity traders are sufficiently risk averse, the slope of equilibrium price schedule rises over time, while informed trading intensities fall. In particular, Kyle's result holds only when liquidity traders are so risk averse that they ‘over-rebalance’ their portfolio's holdings of the risky asset, so that their final holdings of the risky asset have the opposite sign of their initial position.