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Estimating the adverse selection and fixed costs of trading in markets with multiple informed traders

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  • Sugato Chakravarty
  • Asani Sarkar
  • Lifan Wu

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 customers' 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 selected 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 (fixed) costs of trading are a single-peaked (U-shaped) function of m. The implication from our theory is that the dual traders in these contracts exhibit risk averse behavior.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Research Paper with number 9814.

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Date of creation: 1998
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Handle: RePEc:fip:fednrp:9814

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Keywords: Futures ; Risk;

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  1. L. Wade, 1988. "Review," Public Choice, Springer, vol. 58(1), pages 99-100, July.
  2. Madhavan, A. & Smidt, S., 1991. "A Baysian Model of Intraday Specialist Pricing," Weiss Center Working Papers 2-91, Wharton School - Weiss Center for International Financial Research.
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  4. Sarkar Asani, 1995. "Dual Trading: Winners, Losers, and Market Impact," Journal of Financial Intermediation, Elsevier, vol. 4(1), pages 77-93, January.
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  14. Working, Holbrook, 1967. "Tests of a Theory Concerning Floor Trading on Commodity Exchanges," Food Research Institute Studies, Stanford University, Food Research Institute.
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  16. 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, vol. 4(4), pages 623-56.
  17. Silber, William L, 1984. " Marketmaker Behavior in an Auction Market: An Analysis of Scalpers in Futures Markets," Journal of Finance, American Finance Association, vol. 39(4), pages 937-53, September.
  18. Glosten, Lawrence R. & Harris, Lawrence E., 1988. "Estimating the components of the bid/ask spread," Journal of Financial Economics, Elsevier, vol. 21(1), pages 123-142, May.
  19. Brennan, Michael J & Subrahmanyam, Avanidhar, 1998. "The Determinants of Average Trade Size," The Journal of Business, University of Chicago Press, vol. 71(1), pages 1-25, January.
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Cited by:
  1. Sugato Chakravarty & Asani Sarkar, 1999. "Liquidity in U.S. fixed income markets: a comparison of the bid-ask spread in corporate, government and municipal bond markets," Staff Reports 73, Federal Reserve Bank of New York.

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