medium · Market Microstructure mmf-core

Kyle's (1985) single-period model gives the equilibrium price-impact (illiquidity) parameter λ = (1)/(2)√((σ_v^2)/(σ_u^2)), where σ_v^2 is the variance of the asset's terminal value and σ_u^2 the variance of noise (liquidity) order flow. Suppose a regulator's policy simultaneously doubles σ_u^2 and doubles σ_v^2. The new λ and the informed trader's equilibrium expected profit, respectively, will:

1. λ stays the same, while the informed trader's expected profit increases
2. λ stays the same, while the informed trader's expected profit is unchanged
3. λ doubles, while the informed trader's expected profit is unchanged
4. λ halves, while the informed trader's expected profit decreases

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