Dynamic Adverse Selection and Liquidity
49 Pages Posted: 4 Jun 2018 Last revised: 5 May 2020
Date Written: May 4, 2020
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. This latter effect offsets the adverse selection effect when the trading frequency is equal to one, and dominates at larger frequencies.
Keywords: Learning, adverse selection, dynamic model, stationary distribution
JEL Classification: G14, D82
Suggested Citation: Suggested Citation