Profitable informed trading in a simple general equilibrium model of asset pricing

We present a simple general equilibrium model of asset pricing in which profitable informed trading can occur without any ''noise'' added to the model. We use an equilibrium concept similar to rational expectations equilibrium, but which explicitly allows for the possibility of adverse selection. We show that models of profitable informed trading must restrict the portfolio choices of uninformed traders: in particular, they cannot buy the market portfolio. In this model, profitable informed trading lowers the welfare of all agents when compared across steady states. (C) 1995 Academic Press, Inc.