How does asymmetric information and bid-ask spread are connected? For instance, economic theory tells us that, the more the problem of information asymmetry, the higher the spread is. What is the intuition behind it? Can this change? Furthermore, what is the difference between asymmetric information, incomplete infortation and imperfect information?
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1$\begingroup$ Please post separate questions separately. Also, please look around in case there are similar questions on the site, e.g., this one. $\endgroup$– GiskardFeb 18, 2020 at 17:09
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$\begingroup$ "For instance, economic theory tells us that, the more the problem of information asymmetry, the higher the spread is." How so? Any reference? $\endgroup$– Michael GreineckerJul 17, 2020 at 23:05
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$\begingroup$ @Michael Greinecker You can see in Glosten and Milgrom 1985 paper where the spread is a purely informational phenomenon. Specifically, Glosten and Milgrom show that a market maker in order to control the adverse selection problem she lowers the bid or/and increases the ask price. The intuition is that the market maker makes losses when she trades with better informed traders and she offsets this losses by making some gains when she trades with traders who do not have any special information about the futeure payoff of the security. $\endgroup$– Nav89Jul 21, 2020 at 13:52
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$\begingroup$ To sum up, the idea is that when information asymmetry exists, even in the case where the marekt maker has a zero profit contidion, i.e. she is not making any profits of her intermediation role, there is a difference between the price that the security is sold and the one that it is bought. Therefore, the marekt maker, in order to protect herslef from the potenital losses with the informed traders transactions, she adjusts the spread to compensate herslef when she trades with uninformed traders. Hwncw, we result to a wider spread. $\endgroup$– Nav89Jul 21, 2020 at 13:57
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$\begingroup$ However, as fas as I know, there are some empirical evidences that there is a negative relation between the spread and information asymmetry in the paper of Huang and Stoll (1997)...But I do not know how can someone explain this... $\endgroup$– Nav89Jul 21, 2020 at 13:59
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You want to look at a previous post: Imperfect vs incomplete information .
Basically complete information relates to the assumption that players have common knowledge about the game and the utility function of all players. However, they may not know the cards that a player was dealt with, or there might be an action taken by some player that they do not observe.
Perfect information relates to observing all moves and strategies available to a player, but perhaps not knowing the utility or being uncertain about the game. Examples of perfect but incomplete information are a bit harder to imagine, but the examples I like to think of are board games where players have secret goals or missions.
Asymmetric information intersects with both of these classifications. A game has asymmetric information if one player has more information than another player. That is, perhaps one player has complete information and the other one has incomplete information, or perhaps one player has perfect information and the other one has imperfect information. There are many examples here, perhaps one of the most famous ones is the market for used cars, where the seller usually knows better the condition of the car than the buyer. I.e. the information is asymmetric.
Your question about the bid-ask spread is a bit too general. I think that people have used economic theory to rationalize the existence and size of the bid-ask spread. To my knowledge, there are many reasons why this spread exists, and some of these mechanisms have nothing to do with the information.
For example, consider the market for currencies. If in a small town there is a single bank that exchanges currency X for currency Y and vice versa. The bank has market power and can get away with a large bid-ask spread. Even if there is complete, perfect and symmetric information, people might prefer to exchange currencies at a relatively large ask and a relatively low bid, instead of traveling to the next town to find a different bank.
Pertaining information, I can think of traders in the financial market exchanging currencies. If there is a dealer with better information as to where to find more favorable exchange rates, it will have more leeway to increase their own bid-ask spread. Since the their clients might not know there are better options out there in the market.
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$\begingroup$ thank you for your answer it is very helpful. Concernig about the spread, and the dealer case, I will generalize it more. I think of the case of the monopolist dealer of a stock in the stock market. $\endgroup$– Nav89Feb 18, 2020 at 23:03
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$\begingroup$ What is known from the literature has to do with the case that an intermediary does not have any infromation in relation to the stock, except from the trading volume (since he knows the orders that are cleared by him) and some information about the fundamentals of the security, i.e dividents, earnings. There are traders in the market who have private inforamtion about the stock and will try to take advantage of it in any case. $\endgroup$– Nav89Feb 18, 2020 at 23:03
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$\begingroup$ So since the deler does not know the type of his counterparty (infromed or uninformed), he raises the spread and lowers the liquidity of the traded asset. I think this is the idea...contrarily there maybe other theories on this case which bid-ask and information asymmetry are conneted somehow. $\endgroup$– Nav89Feb 18, 2020 at 23:03
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$\begingroup$ Hi: Papers from science direct are often very difficult to obtain in pdf format but, if you can get your hands on this paper, it's kind of the "old landmark" as far as bid ask spread and information asymmetry. sciencedirect.com/science/article/abs/pii/0304405X85900443 $\endgroup$ Jul 18, 2020 at 13:41