A Specialist's Quoted Depth as a Strategic Choice Variable: An Application to Spread Decomposition Models

Abstract

Although there is a sizable literature demonstrating that liquidity and transaction costs are multidimensional, researchers continue to estimate adverse-selection costs using only prices. We present a model of a profit-maximizing specialist who posts prices and depths. The model is simulated to measure changes in the adverse-selection component of the spread that result under different levels of informed trading. We find that spread decompositions fail to capture the full extent of adverse-selection risk when specialists choose depth. We recommend that researchers use adverse-selection measures that account for depth as well as spread to mitigate this problem. 2006 The Southern Finance Association and the Southwestern Finance Association.

The Impact of Adverse Selection on Stock Exchange Specialists’ Price Quotation Strategy

“…However, they found no evidence that specialists revise the price schedule in response to changes in their inventory. Caglio and Kavajecz (2006) were the first to examine whether adjusting liquidity's quantitative dimension, i.e. depth, gives rise to a specification error in the spread decomposition model.…”

“…The basis of the model is the paper written by Caglio and Kavajecz (2006), which we supplemented with a number of new elements and methods:…”

“…The study is based, on the one hand, on a paper by Kornis (2017) that focused on the behaviour and presumed strategies of specialists in quote-driven markets, which we supplemented with the inclusion of quoted volume. On the other hand, the article by Caglio and Kavajecz (2006) also serves as a basis for our study, as the authors demonstrate that specialists can use quoted volumes strategically to mitigate the risk of adverse selection. The concept of adverse selection is presented in this study as a scenario where some of the market participants placing orders are informed about the expected price movement of the product, while others are uninformed and act as liquidity traders.…”

“…Drawing partly from the work of Caglio and Kavajecz (2006) and partly from Kornis (2017), our model includes numerous new assumptions and new methods. The former study primarily provided a theoretical background, while the latter inspired ideas in the area of practical execution.…”

“…After the introduction, in the second section of the study we provide an overview of the relevant international literature. The third section presents the model proposed by Caglio and Kavajecz (2006) supplemented with our own additions and methods. We attempt to explore possible ways of introducing the problem of adverse selection into the model and examine who exactly acts as informed traders, who are liquidity traders, and how can specialists identify them in order to maximise their profits.…”