medium · Market Microstructure Adverse Selection & Information Asymmetry
An informed trader with a private value estimate V and a market price P only enters the market if |V - P| > c.
If information asymmetry increases such that the variance of V expands, how does the behavior of the value trader impact market liquidity?
- Liquidity increases because more value traders enter the market to capture the larger mispricing.
- The market becomes more resilient as value traders provide more depth at every price level.
- Spreads remain constant as the dealer can distinguish between value traders and noise traders.
- Liquidity decreases because the dealer's adverse selection risk rises, forcing wider spreads.
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