# Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim

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Market Microstructure Bid-Ask Spreads and PIN Daniel Sungyeon Kim

into what two components? Adverse selection component Transaction cost component

Four-way Decomposition of the spread
Adverse selection component Transaction cost component can be further decomposed into three pieces: Inventory risk component – compensates dealers for bearing price risk their inventory Order processing cost component – compensates dealers for their normal cost of doing business Monopoly profits component – extra profits that can be extracted by monopoly power

Four-way Decomposition of the spread
Recent estimate by Henker and Martens: Adverse selection = 15% of spread = 1.0 cents Inventory risk = 17% of spread = 1.2 cents Order processing = 65% of spread = 4.5 cents Monopoly profits = 3% of spread = 0.2 cents Total spread = 6.9 cents

Explanations for Adverse Selection Comp.
What are the two explanations for adverse selection component? Information perspective Accounting perspective

Figure 14-1 Ask0 = V0 + (1/2) Adv Selection + (1/2) Transaction Cost
Bid0 = V0 – (1/2) Adv Selection – (1/2) Transaction Cost Figure directly shows information perspective: If buy trade, value increases from If sell trade, value decreases from

Figure 14-2 Suppose there is a buy trade, value increases from

“Most Important Lesson in this Book for Most Readers”

Easley, Keifer, O’Hara, and Paperman
Develop a simple, classic model of adverse selection Can estimate how much informed trading in any stock  PIN = Probability of INformed trade = % of traders that are informed

PIN Computation Chance of Informed Sell = Chance of Informed Buy =
Chance of Informed Trade = Chance of Uninformed Trade= PIN = % of traders that are informed

A PIN example Day Buys Sells 1 53 49 2 74 51 3 48 78 4 50
Best guess of α? Two events out of four trading days = 0.50. Best guess of δ? One good event, one bad event; 0.50 Best guess of ε? 50 Best guess of μ? 25 Best guess of PIN? .5x50 / (.5x50 + 2x50) = 25 / 125 = 20%

PIN Model Dynamics Some traders are informed and others are uninformed
Trading is anonymous  Market makers don’t know which trader is informed vs. uninformed  Every trade causes a price reaction Every sell causes a lower bid and ask Every buy causes a higher bid and ask

= PIN

PIN Sampler e m Vega PIN parameters year-by-year a d PIN

PIN Sampler Agudelo In Indonesia, who is more informed: foreigners
or locals PIN(foreigners) vs. PIN(locals)

PIN Sampler Easley, Engle, O’Hara, Wu Dynamic PIN model PIN estimates
for 16 stocks

PIN Sampler Easley, De Prado, O’Hara Modified Version of PIN = VPIN
during for the 2010 Flash Crash