Sequential Trade Model for Asymmetrical Information

Bid-Ask spread dynamics under asymmetrical information

Introduction

In my recent series of articles, I studied the statistical properties of the Roll Model, a simple framework to approach the concepts of the Bid-Ask spread dynamics. In this piece, I will further explore this topic by assuming that the market is populated by two types of agents with two different sets of information: fully informed and completely uninformed traders. Fully informed traders already know the security’s end-of-day value, while uninformed traders don’t. To address this scenario, I will use a specific case of Glosten and Milgrom¹ model, to analyse how different levels of information among market participants influence overall market activity and define trading strategies.

When agents come to the market to trade, the new information that comes with every trade makes the market maker update his beliefs of how many informed traders are there. I will show a simulation under this model of the bid ask spread dynamics.

As agents enter the market to trade, each transaction introduces new information, leading the market maker to revise his assumptions about the presence of informed traders. I will present a simulation based on this model that explores the dynamics of the bid-ask spread.

This article follows what I learned reading Empirical Market Microstructure² by Joel Hasbrouck and provides additional…