5 - Adverse selection, trading, and spreads Flashcards
Dealers
profit-motivated traders who profit by supplying liquidity to other traders who want to trade
- dealers respond to demands for liquidity, passive traders
bid-ask spread
spread between bid and offer
quote sizes
sizes that they are willing to trade
effective spread:
difference between the prices at which the dealers actually buy and sell
- traders trade with dealer at prices inside the quote
- dealers adjust their quotes between trades
narrow spread
encourages others to trade with them
wide spread
to recover costs of doing business
adverse selection:
tendency of higher risk individuals to seek insurance coverage
financial adverse selection
informed traders select profitable side of market to trade
Lessons from Kyle’s (1985) model:
- if noise trader volume increases, informed trader’s trade volume INCREASES
- if information that informed trader has is significant, informed trader’s trade volume DECREASE
Dealers’ costs come from:
- cost of ignorance
- hit by better informed traders
- cost of carrying an unbalanced inventory
If dealer only charges for transaction costs:
transaction prices will bounce between quoted bid and ask
transaction cost component covers:
- dealers’ time
- memberships, dues and data feeds
- back office operations
- monopolistic rents
determinants of transaction cost:
- trading volume
- number of dealers and limit order traders
if dealers set spreads to cover only transaction costs, eventually will go out of business
- need to widen spread to cover their losses to informed traders
- adverse selection spread component
Asymmetric information tends to:
produce positive serial correlation in price changes
Best estimate of value is
(1-p) V + p ( V+E)
Ask price = V + pE
Bid price = V - pE
Bid-ask spread is 2pE
transaction cost component should have __ long-run effect on price because it is unrelated to information
no
Price changes due to adverse selection component have a _____ effect on prices as dealers infer values from the order flow
permanent
Who supplies liquidity in an order driven market?
- Patient recommitted traders
- Value-motivated traders
Take liquidity
submitting a market order and enabling another investor’s limit order to execute
Information event
news that affects all investors’ assessment of a security’s share value
liquidity event
events that are unique to an individual trader
What must bid-ask spread be equal to have an indifference between limit and market orders?
Zero
