Estimating the Adverse Selection and Fixed Costs of Trading in Markets with Multiple Informed Traders

Posted: 7 Jul 1998

See all articles by Sugato Chakravarty

Sugato Chakravarty

Purdue University

Asani Sarkar

Federal Reserve Bank of New York

Lifan Wu

California State University, Los Angeles - Department of Finance and Law

Date Written: April 1998

Abstract

We investigate, both theoretically and empirically, the relation between the adverse selection and fixed costs of trading and the number of informed traders in a financial asset. As a proxy for informed traders, we use dual traders---i.e., futures floor traders who execute trades both for their own and customer accounts on the same day. Our theoretical model shows that dual traders optimally mimic the size and direction of their informed customers' trades. Further, the adverse selection (fixed) costs of trading: (1) decrease (increase) with the number of dual traders m, if dual traders are risk neutral; and (2) are a single-peaked (U-shaped) function of m, if dual traders are risk averse.

Using data from four futures contracts, we find that the number of dual traders are a significant determinant of both the adverse selection and fixed costs of trading, after controlling for the effects of other determinants of market liquidity. In addition, for three of the four contracts, the estimated adverse selection (fixed) costs of trading are a single-peaked (U-shaped) function of m.

JEL Classification: G12

Suggested Citation

Chakravarty, Sugato and Sarkar, Asani and Wu, Lifan, Estimating the Adverse Selection and Fixed Costs of Trading in Markets with Multiple Informed Traders (April 1998). Available at SSRN: https://ssrn.com/abstract=87111

Sugato Chakravarty (Contact Author)

Purdue University ( email )

Consumer Sciences
1262 Matthews Hall Rm 214F
West Lafayette, IN 47906
United States
765-494-6427 (Phone)
765-494-0869 (Fax)

HOME PAGE: http://web.ics.purdue.edu/~sugato

Asani Sarkar

Federal Reserve Bank of New York ( email )

Research Department
33 Liberty Street
New York, NY 10045
United States
212-720-8943 (Phone)
212-720-1582 (Fax)

HOME PAGE: http://www.newyorkfed.org/research/economists/sarkar/pub.html

Lifan Wu

California State University, Los Angeles - Department of Finance and Law ( email )

5151 State University Dr
Los Angeles, CA 90032
United States
213-343-2870 (Phone)

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