A SPECIALIST'S QUOTED DEPTH AS A STRATEGIC CHOICE VARIABLE: AN APPLICATION TO SPREAD DECOMPOSITION MODELS

Cecilia Caglio and Kenneth A. Kavajecz

Journal of Financial Research, 2006, vol. 29, issue 3, 367-382

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.

Date: 2006
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https://doi.org/10.1111/j.1475-6803.2006.00184.x

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