Lecture 5

Adverse Selection, Trading and

Spreads
• What is the bid-ask spread?
• What is adverse selection?
• How does a dealer decide what to charge?
• What affects the spread on an order-driven market?

Dr. Yuanji Wen Chapter 5 FINA3307

Yuanji.wen@uwa.edu.au Trading in Securities
Markets
Recap - Harris 2003 p199 Figure 8-1
Principals

Utilitarian Profit Motivated Futile

Traders Traders Traders

Investment/Disinvestment
Speculators Dealers
Risk Sharing
Informed Parasitic
Asset Exchanges
Traders Traders
Risk Exchanging
Value-Motivated
Gambling Traders Order Anticipators Bluffers

Tax Reasons Headline Traders

Front
Runners
Information-oriented
Technical Traders
Sentiment-oriented
Technical Traders
Arbitrageurs

Squeezers

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Related Chapters

 Teall, 2018, Chp 5

 Hasbrouck, Chp 7

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Dealers and the bid-ask spread

 Dealers are profit-motivated traders who profit by

supplying liquidity to other traders who wants to trade.
• Dealers respond to demands for liquidity.
Passive traders

 Dealers quote prices at which they are willing to buy

and sell. Dealers must decide:

Where to bid and offer prices

The spread between the bid and offer bid-ask spread
The sizes that they are willing to trade quote sizes

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Dealer Quotes

 The quoted bid-ask spread Ask1

Ask2
• Dealer 1: Ask1 minus Bid1= 5 cents
• Dealer 2: Ask2 minus Bid2 = 5 cents Bid1
Bid2
 It can be different from inside spread.
• In this example: Ask2 minus Bid1 = 3 cents
• Recall: NBBO in previous lecture
• Inside spread usually is much narrower than the average
dealer spread.
 It can be also different from effective spread
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Dealer Quotes

 Effective spread is the 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

Ask
Bid

Time 6

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Dealers and the bid-ask spread

 In the dealer market, dealers set their bid/ask spread to

maximise their profits.

Narrow Wide

Encourage others To recover costs

to trade with of doing
them business
 Depending on the competition in the market:
• Monopolistic dealers
• Competitive dealer markets

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What is adverse selection? Akerlof –
The Market for “Lemons”

 “Tendency of higher risk individuals to seek insurance

coverage”.
• “Pre-contractual opportunism where one contracting party
uses his private information to the counter party’s
disadvantage”
• Example...

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What is adverse selection?

 In financial trading, “adverse selection occurs when one

trader with secret or special information uses that
information to her advantage at the expense of her
counterparty in trade”.

 Informed traders select the profitable side of the

market on which to trade.
• The process is called adverse selection.
• i.e. their selection is adverse to interests of those they trade
with.

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Lessons from Kyle’s (1985) model

 Consider following...
• If two rational traders have access to the same information,
will they trade?
• If they have access to different information and are
otherwise identical, will they trade?
• When will trading take place?

 Kyle (1985) - theoretical model describes the trading

behaviour of informed traders and uninformed market
makers in an environment with noise traders.
• includes liquidity traders

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Lessons from Kyle’s (1985) model

 Who are in this one-period single price auction model?

• Single dealer
– Observe demand and supply in auction and set price
accordingly
• Many uninformed noise traders
– Trade requirement is random but has a distribution that is
known
• Single informed trader with perfect information
– Seek to disguise himself and information
– Determine the optimal trade quantity to maximise profit

 All are risk neutral, no spread, money has no time value.

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Lessons from Kyle’s (1985) model

 How does the dealer set his price?

• Dealer’s pricing function is related to the demand and supply
in the market.
1
p =E (v) + λ ( x + u ) f (Σ 0 , σ u2 )
2
• Kyle’s lamda: sensitivity of the dealer price to order flow
– the dealer’s perception of sensitivity of intrinsic value to
volume
• Depends on the volatility in the intrinsic value and variance in
uninformed traders’ trading.
– If volatility in the intrinsic value is high?
– If the variance in uninformed traders’ trading is high?

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Lessons from Kyle’s (1985) model

 Implications for the informed trader

• If noise trader volume increases, how will that affect the
informed trader’s trade volume?
– Increase!
• If the information that the informed trader has is
“significant”, how will that affect the informed trader’s trade
volume?
– Decrease...

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Lessons from Kyle’s (1985) model

 What does the model say about the dealer’s gains and
losses?

 Can dealer markets exist without liquidity traders?

 The dealers’ costs comes from:

• Cost of ignorance
– Hit by better informed traders
• Cost of carrying an unbalanced inventory

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ASIDE: Beyond Kyle’s (1985)

 Theoretical predictions by Holden and Subrahmanyam (1992).

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ASIDE: is it true?

 Empirical findings by Bossaearts, Frydman and Ledyard (Review of Finance, 2013)

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The components of the bid-ask spread:
Transaction cost component
 The transaction cost component covers
• The dealers’ time.
• Memberships, dues and data feeds.
• Back office operations.
• Monopolistic rents, if any.

 Determinants of transaction cost

• Trading volume.
• Number of dealers and limit order traders.

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The components of the bid-ask spread:
Transaction cost component
 If the dealer only charges for transaction costs,
transaction prices will bounce between the quoted bid
and ask.

Ask
Bid

Time 19

• Negative serial correlation in the price changes

• Transaction cost component

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The components of the bid-ask spread:
Adverse selection spread component
 If dealers set spreads to cover only transaction costs –
eventually go out of business.
• Need to widen spread to cover their losses to informed traders
• Adverse selection spread component
 (Information perspective) it is the difference in the value
estimates that dealers make conditional on the next trader
being a buyer or a seller;
 (Accounting perspective) the portion of the bid-ask spread
that dealers must quote to recover from uninformed traders
what they expect to lose to informed traders
 Empirics: Asymmetric information tends to produce
positive serial correlation in price changes.

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Understanding AS spread component:
Information asymmetry model
 q be the probability that the next buyer is a well-
informed trader.
 E be the error in the dealer’s estimate of value if the
next buyer is well-informed.

• If the next buyer is informed, then value should be V + E.

• If the next buyer is uninformed, then value should be V.

 Best estimate of the value is

(1-q)V + q (V + E)
Ask price = V + qE

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Understanding AS spread component:
Information asymmetry model
• If the next seller is informed, then value should be V - E.
• If the next seller is uninformed, then value should be V.

 Best estimate of the value is

( 1 - q ) V + q ( V - E)
Bid Price = V - qE

Bid-ask spread is V + qE minus V – qE

i.e. 2qE

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Understanding AS spread component:
Information asymmetry and adverse selection
 What actions will the dealer take if...
• There are many informed traders (q is large).

• Informed traders have material information (E is large).

Which of the firms would have higher information asymmetry?

Mining stocks vs blue chip industrial stocks

Contracts on macro variables vs those on individual stocks
Firms with poor accounting systems vs with good systems

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To compute the total spread

Value

V0

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The total spread

Value

Ask0
If buyer V0A
arrives
V0

If seller V0B The Transaction Cost

arrives Component
Bid0

The Adverse Selection

Component
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After a buyer arrives

Value
Ask1
If buyer V1A
Ask0 arrives
V1 = V0A

If seller
V0 V1B
arrives
Bid1
V0B
Bid
0

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Discriminating between the two spread
components

 The transaction cost component should have no long-

run effect on price because it is unrelated to
information.

 Price changes due to the adverse selection component

have a permanent effect on prices as dealers infer
values from the order flow.

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“Market makers” in an order-driven market
 There is no one (like dealers) who continuously provide quotes and
trade against whoever needs immediacy. Then, who makes market in
an order-driven market?
• Officially: Designated Market Makers (DMM) in US market such as NYSE,
AMEX.

 Theoretically two groups of liquidity suppliers classified by their

primary motive for trading:
• Passive liquidity suppliers
– They generally will not trade unless impatient traders demand liquidity.
– Dealers, DMMs or similar

• Precommitted liquidity suppliers

– Offer liquidity only to lower the cost of trades that they already intend to
make, but which they are in no hurry to complete.
– Speculators, investors, hedgers, asset exchangers or gamblers

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“Market makers” in an order-driven market
– Designated Market Makers (DMM)
 Who are them?
• Firms that offer trading services including proprietary trading firms

 What they need to do? – obligations

• Maintain market liquidity for certain stocks
• In practice, the requirements vary across stock exchanges
– NYSE: no obligation to narrow the bid-ask spread; must quote
at the NBBO at least 15% of the time and maintain quotes not
more than 8% away from the NBB/NBO.

 What they gain? – Benefits

• Monetary incentives such as declining fee schedule provided by
stock exchange

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Simple model of the order-driven market

 In an order driven market, each investor individually

determines whether to:
Place a limit order and enable
another investor to buy or sell by
market order
Provide liquidity
Submit a market order and enable
another investor’s limit order to
execute
Take liquidity

 Two events possible:

News that affects all investors’ Events that are unique to an
assessment of a security’s share individual trader.
value.

Information event Liquidity event

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Simple model of the order-driven market

 If only information event occurs, then the limit order

traders will always lose.

Sellers Buyers
Broker Size Price Size Broker
444 5 10.14
555 3 10.12
10.10
10.09 4 222

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Simple model of the order-driven market

 The arrival of liquidity-motivated traders however

creates profit opportunity for the limit order traders.

Sellers Buyers
Broker Size Price Size Broker
444 5 10.14
555 3 10.12
10.10
10.09 4 222

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Simple model of the order-driven market

 Suppose that all traders in this market are homogenous:

• want to trade the same size,
• no one requires immediacy,
• no information asymmetry,
• costless to amend, cancel orders.

 Traders differ in that some want to buy and some want

to sell.

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What determines the spread in an order-driven
market?
 What is the round trip cost of trading using
market orders and limit orders?

Bid-ask spread Nothing

 What must the bid-ask spread be equal to have an

indifference between limit and market orders?
Zero!
 Some of the assumptions are not realistic...
• Costly limit order management
• Asymmetrically informed traders
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Last slide

 Lecture quiz
• LMS: Week 5 folder

 Next week:
• Institutional trading and liquidity
– What is liquidity?
– Who are institutional investors?
– Why and how institutions trade?

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