Chap 3 First

Chapter 3: Adverse Selection in Financial Markets: The Glosten-
Milgrom (1985) model
determinants of the bid-ask spread.

Continuous markets are characterized by the bid and ask prices at which trades can take
place. The bid-ask spread reflects the difference between what active buyers must pay and what
active sellers receive. It is an indicator of the cost of trading and the illiquidity of a market.
Alternatively, illiquidity could be measured by the time it takes optimally to trade a given quantity of
an asset [Lippman and McCall (1986)]. The two approaches converge because the bid-ask spread can
be viewed as the amount paid to someone else (i.e. the dealer) to take on the unwanted position and
dispose of it optimally. Our focus is on the bid-ask spread. Bid-ask spreads vary widely. In inactive
markets – for example, the real estate market – the spread can be wide. A house could be offered at
$500,000 with the highest bid at $450,000. On the other hand the spread for an actively traded stocks
is today often less than 10 cents per share. A central issue in the field of microstructure is what
determines the bid-ask spread and its variation across securities.
Several factors determine the bid-ask spread in a security. First, suppliers of liquidity, such as the
dealers who maintain continuity of markets, incur order handling costs for which they must be
compensated. These costs include the costs of labor and capital needed to provide quote information,
order routing, execution, and clearing. In a market without dealers, where limit orders make the
spread, order handling costs are likely to be smaller than in a market where professional dealers earn
a living. Second the spread may reflect non competitive pricing. For example, market makers may
have agreements to raise spreads or may adopt rules, such as a minimum tick size, to increase
spreads. Third, suppliers of immediacy, who buy at the bid or sell at the ask, assume inventory risk
for which they must be compensated. Fourth, placing a bid or an ask grants an option to the rest of
the market to trade on the basis of new information before the bid or ask can be changed to reflect the
new information. Consequently the bid and ask must deviate from the consensus price to reflect the
cost of such an option. A fifth factor has received the most attention in the microstructure literature;
namely the effect of asymmetric information. If some investors are better informed than others, the
person who places a firm quote (bid or ask) will lose to investors with superior information.
The factors determining spreads are not mutually exclusive. All may be present at the same time. The
three factors related to uncertainty – inventory risk, option effect and asymmetric information – may
be distinguished as follows. The inventory effect arises because of possible adverse public
information after the trade in which inventory is acquired. The expected value of such information is
zero, but uncertainty imposes inventory risk for which suppliers of immediacy must be compensated.
The option effect arises because of adverse public information before the trade and the inability to
adjust the quote. The option effect really results from an inability to monitor and immediately change
resting quotes. The adverse selection effect arises because of the presence of private information
before the trade, which is revealed sometime after the trade. The information effect arises because
some traders have superior information.
The sources of the bid-ask spread may also be compared in terms of the services provided
and the resources used. One view of the spread is that it reflects the cost of the services provided by
liquidity suppliers. Liquidity suppliers process orders, bear inventory risk, using up real resources.
Another view of the spread is that it is compensation for losses to informed traders. This
informational view of the spread implies that informed investors gain from uninformed, but it does
not imply that any services are provided or that any real resources are being used.

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Chapter 3: Adverse Selection in Financial Markets: The Glosten-

Milgrom (1985) model

determinants of the bid-ask spread.

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