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

Abstract

This paper focuses on the activity of the specialists -one of the key participants in stock exchange trading. We attempt to model the price quotations of specialists in a modelling framework where some of the parties involved in the transactions may be informed, while others are uninformed "liquidity traders". It is in this adverse selection modelling framework that, relying on the technique of Monte Carlo simulation, we seek an answer to the following research questions: how does adverse selection impact the price quotation of specialists; to what extent are prices and logreturns influenced by uncertainty; to what degree of accuracy can specialists determine the proportion of informed traders and liquidity traders from trading volumes? Our model confirmed that as soon as uncertainty subsided in the simulated market, the number of transactions, wealth and the stock portfolio started to grow, while price fluctuations began to decline and the standard deviation and the distribution of logreturns edged closer and closer to a normal distribution, which points to improving market efficiency.Journal of Economic Literature (JEL) codes: G12, G14, G17