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How Important Is Informed Trading for the Bid-Ask Spread? Evidence from an Emerging Market

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  • Jan Hanousek
  • Richard Podpiera

Abstract

The link between informed trading and the bid-ask spread has been the focus of abundant literature and some authors feared that a large amount of informed trading might lead to shutdown of markets. We explore this issue using data from the Czech Republic. Our estimates confirm that the share of informed trading and its variability is indeed high relative to developed markets, however, share of the adverse selection component is only 14% of the spread. Since the Czech Republic has been known in the financial community as being plagued by informed trading, our findings suggest that the relative importance of adverse selection as a determinant of the spread is generally low across markets.

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Bibliographic Info

Paper provided by The Center for Economic Research and Graduate Education - Economic Institute, Prague in its series CERGE-EI Working Papers with number wp168.

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Date of creation: Dec 2000
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Handle: RePEc:cer:papers:wp168

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Keywords: market microstructure; informed trading; bid-ask spread; adverse selection;

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References

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  1. Thomas Ho & Hans Stoll, . "On Dealer Markets Under Competition," Rodney L. White Center for Financial Research Working Papers, Wharton School Rodney L. White Center for Financial Research 01-80, Wharton School Rodney L. White Center for Financial Research.
  2. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1996. " Cream-Skimming or Profit-Sharing? The Curious Role of Purchased Order Flow," Journal of Finance, American Finance Association, American Finance Association, vol. 51(3), pages 811-33, July.
  3. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 14(1), pages 71-100, March.
  4. Peter C. Reiss & Ingrid M. Werner, 1998. "Does Risk Sharing Motivate Interdealer Trading?," Journal of Finance, American Finance Association, American Finance Association, vol. 53(5), pages 1657-1703, October.
  5. Easley, David & Kiefer, Nicholas M & O'Hara, Maureen, 1997. "One Day in the Life of a Very Common Stock," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(3), pages 805-35.
  6. Ho, Thomas S Y & Stoll, Hans R, 1983. " The Dynamics of Dealer Markets under Competition," Journal of Finance, American Finance Association, American Finance Association, vol. 38(4), pages 1053-74, September.
  7. George, Thomas J & Kaul, Gautam & Nimalendran, M, 1991. "Estimation of the Bid-Ask Spread and Its Components: A New Approach," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 4(4), pages 623-56.
  8. Affleck-Graves, John & Hegde, Shantaram P & Miller, Robert E, 1994. " Trading Mechanisms and the Components of the Bid-Ask Spread," Journal of Finance, American Finance Association, American Finance Association, vol. 49(4), pages 1471-88, September.
  9. Huang, Roger D & Stoll, Hans R, 1997. "The Components of the Bid-Ask Spread: A General Approach," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(4), pages 995-1034.
  10. Stoll, Hans R, 1989. " Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, American Finance Association, American Finance Association, vol. 44(1), pages 115-34, March.
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Cited by:
  1. Randall K. Filer & Jan Hanousek, 2002. "Data Watch: Research Data from Transition Economies," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 16(1), pages 225-240, Winter.

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