How Well Do Adverse Selection Components Measure Adverse Selection?

Abstract

We examine the performance of five adverse selection models by comparing their component estimates to other measures of information asymmetry and informed trading. The models produce mixed results. Adverse selection components correlate with various volatility measures, but appear unrelated to measures of uncertainty. We find that only three of the five models have the expected relation with our informed trader proxies, suggesting that the adverse selection models measure adverse selection weakly at best. We also find that spread relates to many of the volatility measures, suggesting that some adverse selection components might be measuring some other cost of trading.