Estimating the Adverse Selection Cost in Markets with Multiple Informed Traders

Posted: 18 Sep 1997

See all articles by Sugato Chakravarty

Sugato Chakravarty

Purdue University

Asani Sarkar

Federal Reserve Bank of New York

Lifan Wu

California State University, Los Angeles - Department of Finance and Law

Date Written: March 1997

Abstract

We investigate the relation between the number of informed traders in a financial asset and the estimated adverse selection cost of trading in that asset, lambda, after controlling for the effects of previously identified determinants of market liquidity. As a proxy for informed traders, we use dual traders in futures markets - i.e., floor traders who trade both for customers and their own accounts on the same day. We show, theoretically, that it is optimal for dual traders to mimic both the size and direction of their informed customers' orders. Using data from four selected futures contracts we show that the number of dual traders in a contract is indeed a significant determinant of the adverse selection cost of trading in that contract. We also examine how the adverse selection cost of trading changes with the number of competing dual traders, m, in an asset. Our model demonstrates the existence of a non-monotonic relationship between lambda and m. Specifically, for securities with relatively small numbers of dual traders, there is a positive relationship between lambda and m. For securities with relatively large number of dual traders, there is a negative relationship between lambda and m. Our data indicates a strong support for the non-monotonic relationship between lambda and m. A practical implication of our results is that an observable variable such as the number of broker-dealers in the market can provide an accurate estimation of the adverse selection cost of trading in that market.

JEL Classification: G12, G13, G14

Suggested Citation

Chakravarty, Sugato and Sarkar, Asani and Wu, Lifan, Estimating the Adverse Selection Cost in Markets with Multiple Informed Traders (March 1997). Available at SSRN: https://ssrn.com/abstract=11154

Sugato Chakravarty (Contact Author)

Purdue University ( email )

Consumer Sciences
1262 Matthews Hall Rm 214F
West Lafayette, IN 47906
United States
765-494-6427 (Phone)
765-494-0869 (Fax)

HOME PAGE: http://web.ics.purdue.edu/~sugato

Asani Sarkar

Federal Reserve Bank of New York ( email )

Research Department
33 Liberty Street
New York, NY 10045
United States
212-720-8943 (Phone)
212-720-1582 (Fax)

HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

Lifan Wu

California State University, Los Angeles - Department of Finance and Law ( email )

5151 State University Dr
Los Angeles, CA 90032
United States
213-343-2870 (Phone)

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