| Abstract: | We model trading in a competitive securities market where informed traders and liquidity traders transact with dealers. The dealers' entire published quote is modeled: bid-ask prices and the number of shares the dealer is willing to buy/sell at these prices (i.e., size quotes). We argue that size quotes are a more informative indicator of market liquidity than the bid-ask spread's adverse-selection component. Moreover, the size quotes reveal several market characteristics that cannot be inferred from the bid-ask spread's adverse-selection component alone. The model generates a number of empirically testable predictions that clarify certain key elements of market liquidity. |
