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

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Author Info
Sugato Chakravarty
Asani Sarkar
Lifan Wu

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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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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;

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

  1. Branch, Ben & Freed, Walter, 1977. "Bid-Asked Spreads on the Amex and the Big Board," Journal of Finance, American Finance Association, vol. 32(1), pages 159-63, March. [Downloadable!] (restricted)
  2. Madhavan, Ananth & Smidt, Seymour, 1991. "A Bayesian model of intraday specialist pricing," Journal of Financial Economics, Elsevier, vol. 30(1), pages 99-134, November. [Downloadable!] (restricted)
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  3. Hasbrouck, Joel, 1991. " Measuring the Information Content of Stock Trades," Journal of Finance, American Finance Association, vol. 46(1), pages 179-207, March. [Downloadable!] (restricted)
  4. Brennan, Michael J. & Subrahmanyam, Avanidhar, 1995. "Investment analysis and price formation in securities markets," Journal of Financial Economics, Elsevier, vol. 38(3), pages 361-381, July. [Downloadable!] (restricted)
  5. Brennan, Michael J & Subrahmanyam, Avanidhar, 1998. "The Determinants of Average Trade Size," Journal of Business, University of Chicago Press, vol. 71(1), pages 1-25, January. [Downloadable!] (restricted)
  6. George, Thomas J & Kaul, Gautam & Nimalendran, M, 1991. "Estimation of the Bid-Ask Spread and Its Components: A New Approach," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 4(4), pages 623-56. [Downloadable!] (restricted)
  7. Fishman, Michael J & Longstaff, Francis A, 1992. " Dual Trading in Futures Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 643-71, June. [Downloadable!] (restricted)
  8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November. [Downloadable!] (restricted)
  9. Brennan, Michael J & Jegadeesh, Narasimhan & Swaminathan, Bhaskaran, 1993. "Investment Analysis and the Adjustment of Stock Prices to Common Information," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 6(4), pages 799-824. [Downloadable!] (restricted)
  10. Sanford J. Grossman, . "An Economic Analysis of Dual Trading," Rodney L. White Center for Financial Research Working Papers 33-89, Wharton School Rodney L. White Center for Financial Research.
  11. Manaster, Steven & Mann, Steven C, 1996. "Life in the Pits: Competitive Market Making and Inventory Control," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 9(3), pages 953-75. [Downloadable!] (restricted)
  12. Sarkar Asani, 1995. "Dual Trading: Winners, Losers, and Market Impact," Journal of Financial Intermediation, Elsevier, vol. 4(1), pages 77-93, January. [Downloadable!] (restricted)
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  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. [Downloadable!]
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