Bid, Ask, and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders
Coauthor(s): Paul Milgrom.
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The presence of traders with superior information leads to a positive bid-ask spread even when the specialist is risk-neutral and makes zero expected profits. The resulting transaction prices convey information, and the expectation of the average spread squared times volume is bounded by a number that is independent of insider activity. The serial correlation of transaction price differences is a function of the proportion of the spread due to adverse selection. A bid-ask spread implies a divergence between observed returns and realizable returns. Observed returns are approximately realizable returns plus what the uninformed anticipate losing to the insiders.
Source: Journal of Financial Economics
Glosten, Lawrence, and Paul Milgrom. "Bid, Ask, and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders." Journal of Financial Economics 14, no. 1 (March 1985): 71-100.