Informed Trading, Predictable Noise Trading Activities and Market Manipulation

Traditional models of informed trading typically assume the existence of noise trading activities which generate pure random noise in trading volumes. This paper studies a multi-period model of speculative trading in the presence of a systematic component of the noise trading activities which is privately observed by a monopolistic risk-averse informed trader. Because of the incentive to hide the magnitude of informed trading, the informed trader’s trades may comove with the mispricing caused by the systematic component of noise trading instead of engaging in arbitrage. The result implies that an arbitrageur who has superior information on non-fundamentals such as investor sentiment may not always reduce the mispricing caused by them given private information on fundamentals. This paper demonstrates that market manipulation could easily occur in a standard Kyle model with relatively mild assumptions if private information has more than two dimensions: (i) fundamentals and (ii) non-fundamentals.