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Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders

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What they found

Glosten and Milgrom explain why a bid-ask spread exists even when the market maker has no costs and no monopoly power: adverse selection. Some traders know more than the market maker, so every trade carries a risk of being on the wrong side of information. The market maker protects herself by quoting a bid below and an ask above her estimate of value, and updates her quotes after each trade. The spread widens when informed traders are more numerous or better informed, and can widen so far that the market shuts down.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Bid-ask spread in an order bookSell orders stacked above buy orders with a gap between the best of each.SELLERS (asks)50.0690050.051,40050.0460050.011,10050.002,30049.99800spread = 0.03BUYERS (bids)
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.

What you can use

  • The spread you pay is partly an insurance premium the market maker charges against traders who know more than she does.
  • Spreads widen around news and in thinly traded names because the risk of trading against informed flow is higher.
  • If you trade against a market maker with no information advantage, the spread is a pure cost you must overcome.

Caveats

Theoretical model with a sequential-trade setup; no empirical data. Assumes a single competitive market maker.

Tags: microstructure, theory, bid-ask-spread, adverse-selection

Summaries are our own reading of the paper, not the authors' words. Educational only, not advice. Discuss it in Book Club.