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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

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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  • Cecilia Caglio & Kenneth A. Kavajecz, 2006. "A Specialist'S Quoted Depth As A Strategic Choice Variable: An Application To Spread Decomposition Models," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 29(3), pages 367-382.
  • Handle: RePEc:bla:jfnres:v:29:y:2006:i:3:p:367-382
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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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