Bid ask spread in a competitive market with institutions and order size |
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Authors: | Malay K Dey Hossein Kazemi |
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Institution: | (1) University of Bridgeport, Bridgeport, CT, USA;(2) 1091 Stillson Road, Fairfield, CT 06824, USA;(3) University of Massachusetts-Amherst, Amherst, MA, USA |
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Abstract: | Large orders, particularly from institutions, are quite common these days and hence there is interest to know if institutional
trading has any bearing on the price effect associated with large trades. Recent empirical studies contradict earlier evidence
of negative price effect on selling large blocks and find no price effect associated with large trades. Existing theoretical
framework suggests a monotonic and increasing adverse price effect for large trades, where the motivation for a large trade
is private information. We model a trading system where pure information, information-liquidity, and pure liquidity traders
trade small and large sizes. The pure information traders strategically choose an order size. Institutions trade only large
sizes because of their low execution costs for large trades; they are information-liquidity traders whose ability to use an
information signal to determine their trades is subject to a binding liquidity constraint. We show that in such a market a
separating equilibrium where trade size is informative does not exist and hence there is no price effect for large trades.
Trade size may be revealing only if there is a buy sell asymmetry (large buy size is not equal to large sell size) or the
corresponding price effect is asymmetric (price effect due to a large buy is not equal to that of a large sell). Further for
a pooling equilibrium to exist, where trade size is not informative, the width of the market denoted by the ratio of order
size (large size/small size) needs to be small, while the shallowness (inverse depth) of the market denoted by the ratio between
pure information and institutional trades and the information signal needs to be stronger (higher). Our results on bid and
ask prices and spread confirm recent empirical evidence on price effect of large and institutional trades found in the literature.
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Keywords: | Information asymmetry Sequential equilibrium Order size Security price Bid-ask spread Institutions |
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