medium · Market Microstructure
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 remains constant because λ only depends on the volume of noise traders.
- Liquidity increases (λ decreases) because more information is being incorporated 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 less aggressively.
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