medium · Market Microstructure adverse-selection
In the Kyle (1985) model, if the prior variance of fundamental value Σ_0 increases, what happens to the market's liquidity (as measured by Kyle's lambda λ)?
- Liquidity stays constant, since lambda depends only on noise trader volume, not prior uncertainty.
- Liquidity increases (lambda decreases), because more private information gets steadily built into the price.
- Liquidity decreases (λ increases) because the market maker fears greater losses to the informed trader.
- Liquidity increases because the informed trader will trade much less aggressively given a stronger private signal.
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