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Adverse Selection and Liquidity: From Theory to Practice

Author

Listed:
  • Albert S. Kyle

    (University of Maryland)

  • Anna A. Obizhaeva

    (New Economic School)

Abstract

This paper shows how to map predictions of theoretical models of market microstructure into operational empirical measures of liquidity. A meta-model implies an empirical measure of liquidity, denoted L, which describes various characteristics of trading and funding liquidity such as trading costs, bet sizes, haircuts, and capital requirements. When mapped into existingmodels of adverse selection, themeta-model also describes precisely how adverse selection shows up in pricing accuracy and resiliency. Themeta-model is consistent with models of both block trading and flow trading. It highlights a deep connection between time and adverse selection.

Suggested Citation

  • Albert S. Kyle & Anna A. Obizhaeva, 2020. "Adverse Selection and Liquidity: From Theory to Practice," Working Papers w0268, New Economic School (NES).
    • Handle: RePEc:abo:neswpt:w0268
    as

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    File URL: https://www.nes.ru/files/Preprints-resh/WP268.pdf
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    References listed on IDEAS

    as
    1. Albert S. Kyle & Anna Obizhaeva, 2016. "Large Bets and Stock Market Crashes," Working Papers w0227, New Economic School (NES).
    2. Dimitri Vayanos, 1999. "Strategic Trading and Welfare in a Dynamic Market," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 66(2), pages 219-254.
    3. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
    4. Mark Bagnoli & S. Viswanathan & Craig Holden, 2001. "On the Existence of Linear Equilibria in Models of Market Making," Mathematical Finance, Wiley Blackwell, vol. 11(1), pages 1-31, January.
    5. Albert S. Kyle & Anna Obizhaeva, 2016. "Large Bets and Stock Market Crashes," Working Papers w0227, Center for Economic and Financial Research (CEFIR).
    6. Kyle, Albert S & Wang, F Albert, 1997. "Speculation Duopoly with Agreement to Disagree: Can Overconfidence Survive the Market Test?," Journal of Finance, American Finance Association, vol. 52(5), pages 2073-2090, December.
    7. Anna, Petrenko, 2016. "Мaркування готової продукції як складова частина інформаційного забезпечення маркетингової діяльності підприємств овочепродуктового підкомплексу," Agricultural and Resource Economics: International Scientific E-Journal, Agricultural and Resource Economics: International Scientific E-Journal, vol. 2(1), March.
    8. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
    9. Albert S. Kyle, 1989. "Informed Speculation with Imperfect Competition," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 56(3), pages 317-355.
    10. Albert S. Kyle & Wei Xiong, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, August.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    market microstructure; invariance; liquidity; adverse selection; market impact; bidask spread; bet size; market efficiency; dimensional analysis; leverage neutrality.;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G20 - Financial Economics - - Financial Institutions and Services - - - General

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