The Effect of Insider Trading by a Dominant Trader in a Simple Securities Market Model

Abstract

This paper studies the effects of strategic behavior by an informed trader who is large relative to the remaining traders in a simple securities market model. The strategic interaction among market participants is modelled as a price-setting game in which the dominant trader sets price, taking into account the reactions of uninformed traders who behave competitively. The equilibrium outcomes of this game are compared with those which emerge when all traders act as price-takers and/or all information is public. Besides characterizing the informational efficiency of prices under alternative assumptions and describing the dual advantages conferred by superior information and the ability to move first and set prices, these comparisons help to determine whether observations on equilibrium prices and quantities traded suffice to reveal the existence of. strategic insider trading in an otherwise competitive market.