Estimating the Adverse Selection and Fixed Costs of Trading in Markets with Multiple Informed Traders

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Research Papers

Estimating the Adverse Selection and Fixed Costs of Trading in Markets with Multiple Informed Traders

May 1998 Number 9814

JEL classification: G12

Authors: Sugato Chakravarty, Asani Sarkar, and Lifan Wu

We investigate, both theoretically and empirically, the relation between the adverse selection and fixed costs of trading and the number of informed traders in a financial asset. As a proxy for informed traders, we use dual traders—i.e., futures floor traders who execute trades both for their own and customers' accounts on the same day. Our theoretical model shows that dual traders optimally mimic the size and direction of their informed customers' trades. Further, the adverse selection (fixed) costs of trading: (1 )decrease (increase) with the number of dual traders m, if dual traders are risk neutral; and (2) are a single-peaked (U-shaped) function of m, if dual traders are risk averse. Using data from four selected futures contracts, we find that the number of dual traders are a significant determinant of both the adverse selection and fixed costs of trading, after controlling for the effects of other determinants of market liquidity. In addition, for three of the four contracts, the estimated (fixed) costs of trading are a single-peaked (U-shaped) function of m. The implication from our theory is that the dual traders in these contracts exhibit risk averse behavior.

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