Adverse Selection and Liquidity: From Theory to Practice

Albert Kyle () and Anna Obizhaeva ()
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Albert Kyle: University of Maryland
Anna Obizhaeva: New Economic School

No w0268, Working Papers from New Economic School (NES)

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.

Keywords: market microstructure; invariance; liquidity; adverse selection; market impact; bidask spread; bet size; market efficiency; dimensional analysis; leverage neutrality. (search for similar items in EconPapers)
JEL-codes: G10 G12 G14 G20 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2020-07
New Economics Papers: this item is included in nep-mst
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Persistent link: https://EconPapers.repec.org/RePEc:abo:neswpt:w0268

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