Tick Size and Adverse Selection: Spurious Effects Arising from Serial Correlation

48 Pages Posted: 17 Mar 2009 Last revised: 30 Mar 2012

See all articles by Lynn Doran

Lynn Doran

McDonough School of Business; Georgetown University - Department of Accounting and Business Law

Michael A. Goldstein

Babson College - Finance Division

Evgenia V. Golubeva

University of Oklahoma - Division of Finance

Eric N. Hughson

Claremont McKenna College - Robert Day School of Economics and Finance

Date Written: March 15, 2009

Abstract

In this paper, we demonstrate using a simple model that reducing tick size may either reduce or increase adverse selection. Therefore, the effect of tick size on adverse selection is an important empirical question. At the same time, we demonstrate that the standard asymmetric information models used to estimate effects of informed trading rely on econometric techniques that may give spurious results. Using simulations from an equilibrium model with no asymmetric information but endogenously determined market orders, we demonstrate that standard techniques may generate a positive asymmetric information component even when the true one is zero, and that this upward bias in the adverse selection component is affected by tick size. This bias occurs in part from serial correlation of order flow that may increase under sufficiently small tick sizes due to orders being split.

Keywords: tick size, adverse selection, serial correlation

JEL Classification: G00

Suggested Citation

Lanz Doran, Lynn and Goldstein, Michael A. and Golubeva, Evgenia V. and Hughson, Eric N., Tick Size and Adverse Selection: Spurious Effects Arising from Serial Correlation (March 15, 2009). Available at SSRN: https://ssrn.com/abstract=1360323 or http://dx.doi.org/10.2139/ssrn.1360323

Lynn Lanz Doran

McDonough School of Business ( email )

Georgetown University
Washington, DC 20057
United States
202-687-2688 (Phone)

Georgetown University - Department of Accounting and Business Law ( email )

McDonough School of Business
Washington, DC 20057
United States

Michael A. Goldstein

Babson College - Finance Division ( email )

320 Tomasso Hall
Babson Park, MA 02457-0310
United States
781-239-4402 (Phone)
781-239-5004 (Fax)

HOME PAGE: http://faculty.babson.edu/goldstein/

Evgenia V. Golubeva (Contact Author)

University of Oklahoma - Division of Finance ( email )

307 West Brooks
Room 205A, Adams Hall
Norman, OK 73019
United States
405-325-7727 (Phone)
405-325-7688 (Fax)

Eric N. Hughson

Claremont McKenna College - Robert Day School of Economics and Finance ( email )

500 E. Ninth St.
Claremont, CA 91711-6420
United States
909-607-3664 (Phone)

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