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A Specialist'S Quoted Depth As A Strategic Choice Variable: An Application To Spread Decomposition Models

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  • Cecilia Caglio
  • Kenneth A. Kavajecz
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    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.

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    Bibliographic Info

    Article provided by Southern Finance Association & Southwestern Finance Association in its journal Journal of Financial Research.

    Volume (Year): 29 (2006)
    Issue (Month): 3 ()
    Pages: 367-382

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    Handle: RePEc:bla:jfnres:v:29:y:2006:i:3:p:367-382

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    Web page: http://www.southwesternfinance.org/
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    Cited by:
    1. Buti, Sabrina, 2007. "A Challenger to the Limit Order Book: The NYSE Specialist," SIFR Research Report Series 55, Institute for Financial Research.

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