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Adverse Selection and Large Trade Volume: The Implications for Market Efficiency

Published online by Cambridge University Press:  06 April 2009

David Easley  and
Maureen O'Hara
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Abstract

This paper examines the adverse selection problem that arises from the repeated trades of informed traders. We develop a model of trading that incorporates the interaction of expectations, prices, and volume. We then examine how trading volume affects the speed of price adjustment to information, and demonstrate how this price effect differs across markets. Our results suggest that the efficiency of price adjustment to new information may differ dramatically depending on security market structure, even when there is endogenous entry of informed traders. We illustrate these price adjustment properties by developing a simulation of our theoretical model.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 27 , Issue 2 , June 1992 , pp. 185 - 208
Copyright
Copyright © School of Business Administration, University of Washington 1992

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