Adverse-Selection Costs and the Probability of Information-Based Trading

Abstract

Prior studies offer various empirical models to decompose the observed bid-ask spread into the adverse-selection and transitory (order-processing and inventory-holding) components. There is limited evidence, however, on whether the spread components estimated from these models indeed measure what they purport to measure. In this study, we show that the estimates of the adverse-selection component given by these models are positively and significantly related to the probability of information-based trading (PIN), after controlling for the endogeneity of the PIN and other stock attributes. These results provide direct empirical support for the spread component models examined in the present study.