market microstructure bid ask spreads and pin daniel sungyeon kim n.
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Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim. Bid-Ask spread. The bid-ask spread can be decomposed into what two components? Adverse selection component Transaction cost component. Four-way Decomposition of the spread. Adverse selection component

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bid ask spread
Bid-Ask spread

The bid-ask spread can be decomposed

into what two components?

Adverse selection component

Transaction cost component

four way decomposition of the spread
Four-way Decomposition of the spread
  • Adverse selection component
  • Transaction cost component can be further decomposed into three pieces:
    • Inventory risk component – compensates dealers for bearing price risk their inventory
    • Order processing cost component – compensates dealers for their normal cost of doing business
    • Monopoly profits component – extra profits that can be extracted by monopoly power
four way decomposition of the spread1
Four-way Decomposition of the spread

Recent estimate by Henker and Martens:

Adverse selection = 15% of spread = 1.0 cents

Inventory risk = 17% of spread = 1.2 cents

Order processing = 65% of spread = 4.5 cents

Monopoly profits = 3% of spread = 0.2 cents

Total spread = 6.9 cents

explanations for adverse selection comp
Explanations for Adverse Selection Comp.

What are the two explanations for adverse selection component?

Information perspective

Accounting perspective

figure 14 1
Figure 14-1
  • Ask0 = V0 + (1/2) Adv Selection + (1/2) Transaction Cost
  • Bid0 = V0 – (1/2) Adv Selection – (1/2) Transaction Cost
  • Figure directly shows information perspective:
    • If buy trade, value increases from
    • If sell trade, value decreases from
figure 14 2
Figure 14-2

Suppose there is a buy trade, value increases from

This becomes the new midpoint:

Ask1= V1+ (1/2) Adv Selection + (1/2) Transaction Cost

Bid1= V1– (1/2) Adv Selection – (1/2) Transaction Cost

If next trade = buy, value increases from

If next trade = sell, value decreases from

Change in value = V1–V0 = (1/2) Adv Selection

Adverse Selection = Permanent Component of the spread

Vs. Transaction Cost=Transitory Component of the spread

That is, Ask0 - went away  did not become part of change in value

If the market is Efficient = reflects all available info,

then value changes are unpredictable = Random Walk

most important lesson in this book for most readers
“Most Important Lesson in this Book for Most Readers”

Uninformed traders lose to informed trader regardless of whether they use a limit order or market order

Example: Ask = 30.10, Bid = 30.00, informed have good news that stock is worth 35.00

(1) Uninformed submits limit sell at 30.10

 informed buys at 30.10, price rises to 35.00

 uninformed sold at 30.10 & missed price rise

(2) Uninformed submits limit buy at 30.00

informed submits limit buy at 30.01 (or buys at 30.10)

price rises to 35.00

uninformed limit buy doesn’t execute & misses price rise

(3) Uninformed submits market buy or market sell

 pays the spread, which is wider due to adv select comp

easley keifer o hara and paperman
Easley, Keifer, O’Hara, and Paperman

Develop a simple, classic model of adverse selection

Can estimate how much informed trading in any stock

 PIN = Probability of INformed trade

= % of traders that are informed

pin computation
PIN Computation

Chance of Informed Sell =

Chance of Informed Buy =

Chance of Informed Trade =

Chance of Uninformed Trade=

PIN= % of traders that are informed

pin model dynamics
PIN Model Dynamics

Some traders are informed and others are uninformed

Trading is anonymous

 Market makers don’t know which

trader is informed vs. uninformed

 Every trade causes a price reaction

Every sell causes a lower bid and ask

Every buy causes a higher bid and ask

pin sampler
PIN Sampler

m

e

d

a

PIN

Vega

PIN parameters

year-by-year

pin sampler1
PIN Sampler

Agudelo

In Indonesia,

who is more

informed:

foreigners

or locals

PIN(foreigners)

vs. PIN(locals)

pin sampler2
PIN Sampler

Easley,

Engle,

O’Hara,

Wu

Dynamic PIN

model

PIN estimates

for 16 stocks

pin sampler3
PIN Sampler

Easley,

De Prado,

O’Hara

Modified

Version of

PIN =

VPIN

during for

the 2010

Flash

Crash