We have learned four theories on spread determination in a dealer market.
Consider a strategic dealing theory where:
1. there are many informed and uninformed traders (dealers are uninformed).
2. denote the fundamental (or future) price of the asset as PH and the current market bid and ask as BM and AM.
3. Both know with whom they trade (counterparties).
Provide a condition under which the result on a strategic dealing theory (smaller spread) does not hold. Provide an economic story (how the informed and uninformed traders behave in response to your condition) and market consequence under your condition.
Your answer has to be up to 500 word

four conditions are

1. Operating costs • Spreads wider for smaller trades • Fixed costs of dealing distributed over bigger base

2. Inventory costs • Spreads wider for larger trades • Spreads wider when exchange rate more volatile • More risk from inventory positions with bigger trades and when volatility is higher

3. Adverse selection costs • Spreads wider for larger trades • Spreads wider for “informed” counterparties

4. Strategic dealing theory under asymmetric information

The informed trader: institutional investors: knows PH

The uninformed trader: dealers

Answer rating: 100% (QA)

The result on a strategic dealing theory smaller spread The condition under which the result on a strategic dealing theory does not hold 1 The operati... View the full answer