Dynamic Adverse Selection and Liquidity

49 Pages Posted: 4 Jun 2018 Last revised: 5 May 2020

See all articles by Ioanid Rosu

Ioanid Rosu

HEC Paris - Finance Department

Date Written: May 4, 2020

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. 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

Rosu, Ioanid, Dynamic Adverse Selection and Liquidity (May 4, 2020). Paris December 2018 Finance Meeting EUROFIDAI - AFFI. Available at SSRN: https://ssrn.com/abstract=3190206 or http://dx.doi.org/10.2139/ssrn.3190206

Ioanid Rosu (Contact Author)

HEC Paris - Finance Department ( email )

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

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