Dynamic Adverse Selection and Liquidity

35 Pages Posted: 16 May 2018 Last revised: 16 Nov 2018

See all articles by Ioanid Rosu

Ioanid Rosu

HEC Paris - Finance Department

Multiple version iconThere are 2 versions of this paper

Date Written: November 16, 2018

Abstract

Does a larger fraction of informed trading generate more illiquidity, as measured by the bid-ask spread? We answer this question in the negative in the context of a dynamic dealer market where the fundamental value follows a random walk, provided we consider the long run (stationary) equilibrium. More informed traders tend to generate more adverse selection and hence larger spreads, but at the same time cause faster learning by the market makers and hence smaller spreads. These two effects offset each other in the long run.

Keywords: Learning, adverse selection, dynamic model, stationary distribution

JEL Classification: G14, D82

Suggested Citation

Rosu, Ioanid, Dynamic Adverse Selection and Liquidity (November 16, 2018). Available at SSRN: https://ssrn.com/abstract=3172692 or http://dx.doi.org/10.2139/ssrn.3172692

Ioanid Rosu (Contact Author)

HEC Paris - Finance Department ( email )

1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France

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