Dynamic Adverse Selection and Liquidity
35 Pages Posted: 16 May 2018 Last revised: 16 Nov 2018
Date Written: November 16, 2018
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: Suggested Citation