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Modelling Adverse Selection on Electronic Order-Driven Markets

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Author Info
Louis R. Mercorelli () (School of Finance and Economics, University of Technology, Sydney)
David Michayluk () (School of Finance and Economics, University of Technology, Sydney)
Anthony D. Hall () (School of Finance and Economics, University of Technology, Sydney)

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Abstract

The vast majority of models that decompose the bid/ask spread assume the quote-driven, specialist structure of the NYSE. This paper critically evaluates these models to construct a model specific for an electronic order-driven exchange. The model not only captures adverse selection and the impact of order flows on price discovery but it includes the imbalance of supply and demand inherent in the public limit order book. With this new model we investigate the change to anonymity on the Australian Securities Exchange (ASX). Following the change to anonymity, both adverse selection and the demand/supply imbalance have an increased impact on prices while order flow has a decreased influence, suggesting the change to anonymity has improved market efficiency. The model also uncovers a change in traders? behavior once their fear of front-running is reduced. We show that the model is stable and robust across high liquidity stocks as well as stocks with as few as 5 trades per day.

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Publisher Info
Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 220.

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Length: 47
Date of creation: 01 Mar 2008
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Handle: RePEc:uts:rpaper:220

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Related research
Keywords: bid-ask spread models; adverse selection; anonymity;

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Find related papers by JEL classification:
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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  1. Rudy De Winne & Christophe Majois, 2003. "A Comparison of Alternative Spread Decomposition Models on Euronext Brussels," Brussels Economic Review/Cahiers Economiques de Bruxelles, Editions du DULBEA, Université libre de Bruxelles, Department of Applied Economics (DULBEA), vol. 46(4), pages 91-135.
  2. Comerton-Forde, Carole & Frino, Alex & Mollica, Vito, 2005. "The impact of limit order anonymity on liquidity: Evidence from Paris, Tokyo and Korea," Journal of Economics and Business, Elsevier, vol. 57(6), pages 528-540. [Downloadable!] (restricted)
  3. Neal, Robert & Wheatley, Simon M., 1998. "Adverse selection and bid-ask spreads: Evidence from closed-end funds," Journal of Financial Markets, Elsevier, vol. 1(1), pages 121-149, April. [Downloadable!] (restricted)
  4. Chan, Yue-Cheong, 2000. "The price impact of trading on the stock exchange of Hong Kong," Journal of Financial Markets, Elsevier, vol. 3(1), pages 1-16, February. [Downloadable!] (restricted)
  5. Ananth Madhavan & Matthew Richardson & Mark Roomans, 1996. "Why Do Security Prices Change? A Transaction-Level Analysis of NYSE Stocks," New York University, Leonard N. Stern School Finance Department Working Paper Seires 96-34, New York University, Leonard N. Stern School of Business-.
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  6. Henker, Thomas & Wang, Jian-Xin, 2006. "On the importance of timing specifications in market microstructure research," Journal of Financial Markets, Elsevier, vol. 9(2), pages 162-179, May. [Downloadable!] (restricted)
  7. Huang, Roger D & Stoll, Hans R, 1997. "The Components of the Bid-Ask Spread: A General Approach," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 10(4), pages 995-1034.
  8. Thierry Foucault & Sophie Moinas & Erik Theissen, 2007. "Does Anonymity Matter in Electronic Limit Order Markets?," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 20(5), pages 1707-1747, <. [Downloadable!] (restricted)
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  9. 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)
  10. Goodhart, Charles A. E. & O'Hara, Maureen, 1997. "High frequency data in financial markets: Issues and applications," Journal of Empirical Finance, Elsevier, vol. 4(2-3), pages 73-114, June. [Downloadable!] (restricted)
  11. Glosten, Lawrence R. & Harris, Lawrence E., 1988. "Estimating the components of the bid/ask spread," Journal of Financial Economics, Elsevier, vol. 21(1), pages 123-142, May. [Downloadable!] (restricted)
  12. Easley, David, et al, 1996. " Liquidity, Information, and Infrequently Traded Stocks," Journal of Finance, American Finance Association, vol. 51(4), pages 1405-36, September. [Downloadable!] (restricted)
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  13. Lee, Charles M C & Ready, Mark J, 1991. " Inferring Trade Direction from Intraday Data," Journal of Finance, American Finance Association, vol. 46(2), pages 733-46, June. [Downloadable!] (restricted)
  14. Glosten, Lawrence R, 1994. " Is the Electronic Open Limit Order Book Inevitable?," Journal of Finance, American Finance Association, vol. 49(4), pages 1127-61, September. [Downloadable!] (restricted)
  15. Erik Theissen, 2002. "Trader Anonymity, Price Formation and Liquidity," Bonn Econ Discussion Papers bgse20_2002, University of Bonn, Germany. [Downloadable!]
  16. J. Doyne Farmer & Laszlo Gillemot & Fabrizio Lillo & Szabolcs Mike & Anindya Sen, 2003. "What really causes large price changes?," Quantitative Finance Papers cond-mat/0312703, arXiv.org, revised Apr 2004. [Downloadable!]
  17. Stoll, Hans R, 1989. " Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 115-34, March. [Downloadable!] (restricted)
  18. Ahn, Hee-Joon & Cai, Jun & Hamao, Yasushi & Ho, Richard Y.K., 2005. "Adverse selection, brokerage coverage, and trading activity on the Tokyo Stock Exchange," Journal of Banking & Finance, Elsevier, vol. 29(6), pages 1483-1508, June. [Downloadable!] (restricted)
  19. Choi, J. Y. & Salandro, Dan & Shastri, Kuldeep, 1988. "On the Estimation of Bid-Ask Spreads: Theory and Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(02), pages 219-230, June. [Downloadable!]
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