Flexible Information Acquisition in the Kyle Model
Abstract
"We study an information acquisition problem in which an informed trader acquires costly information prior to trading in the Kyle equilibrium. The cost of information acquisition is represented by an entropy cost. Both the prior distribution of the asset payoff and the signal distribution may be discrete or continuous, and need not be normal. The informed trader designs the optimal signal structure by balancing three forces: the profit potential from the informational advantage, the information leakage cost arising from market makers’ inference, and the cost of information acquisition.We provide a complete characterization of the optimal information acquisition decision. Regardless of the prior distribution of the asset payoff, continuous signals are optimal. Moreover, any continuously distributed signal, together with an associated logit-type posterior distribution of the payoff, yields the same ex-ante value for the informed trader, the same conditional expected payoff given the signal, and the same unconditional distribution of the informed trader’s trading strategy. Consequently, a normally distributed signal can be adopted without loss of generality.
We further show that when the information acquisition cost increases or the volatility of noise trades decreases, the variance of the posterior expected payoff declines, the profit potential from trading diminishes, meanwhile the posterior expected payoff increasingly resembles a normal distribution, and the information leakage cost from trading decreases."