How does adverse selection widen the bid-ask spread?

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AcadiFi · Accepted Answer

Market makers cannot distinguish informed from uninformed (liquidity) traders. When an informed trader buys, the MM sells at the ask and expects to lose money (price will rise). When an uninformed trader buys, no systematic loss. The MM widens the ask above the expected value to compensate for losses to informed flow. Symmetric logic on the bid side. Glosten-Milgrom (1985) framework: if probability of informed trader is pi, asset value is V_high or V_low with equal probability, then: - Ask = E[V | buy order] = pi * V_high + (1-pi) * (V_high + V_low)/2 - Bid = E[V | sell order] = pi * V_low + (1-pi) * (V_high + V_low)/2 Example: Ridgeview Software, V_high=$52, V_low=$48, pi=0.20 (20% informed traders), mean $50. - Ask = 0.20*52 + 0.80*50 = $50.40 - Bid = 0.20*48 + 0.80*50 = $49.60 - Spread = $0.80, or 160 bps If pi rises to 0.40: Ask=$50.80, Bid=$49.20, spread=$1.60 (doubled). More informed trading => wider spreads. ```mermaid flowchart LR A[Informed trader
probability pi up] --> B[MM expects
larger losses] B --> C[Spread widens] C --> D[Liquidity traders
pay more] ``` Implications: before earnings announcements, M&A leaks, or policy surprises, pi rises and spreads widen ahead of public news. Monitoring spread changes can help detect information flow. For liquidity risk, adverse-selection stress scenarios should assume pi spikes during crises, widening spreads beyond normal bid-ask VaR adjustments.

How does adverse selection widen the bid-ask spread?

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