Bid ask spread in a competitive market with institutions
and order size
Malay K. Dey Æ Hossein Kazemi
Published online: 29 September 2007
Ó Springer Science+Business Media, LLC 2007
Abstract Large orders, particularly from institutions, are quite common these days and
hence there is interest to know if institutional trading has any bearing on the price effect
associated with large trades. Recent empirical studies contradict earlier evidence of neg-
ative price effect on selling large blocks and ﬁnd no price effect associated with large
trades. Existing theoretical framework suggests a monotonic and increasing adverse price
effect for large trades, where the motivation for a large trade is private information.
We model a trading system where pure information, information-liquidity, and pure
liquidity traders trade small and large sizes. The pure information traders strategically
choose an order size. Institutions trade only large sizes because of their low execution costs
for large trades; they are information-liquidity traders whose ability to use an information
signal to determine their trades is subject to a binding liquidity constraint. We show that in
such a market a separating equilibrium where trade size is informative does not exist and
hence there is no price effect for large trades. Trade size may be revealing only if there is a
buy sell asymmetry (large buy size is not equal to large sell size) or the corresponding price
effect is asymmetric (price effect due to a large buy is not equal to that of a large sell).
Further for a pooling equilibrium to exist, where trade size is not informative, the width of
the market denoted by the ratio of order size (large size/small size) needs to be small, while
the shallowness (inverse depth) of the market denoted by the ratio between pure infor-
mation and institutional trades and the information signal needs to be stronger (higher).
Our results on bid and ask prices and spread conﬁrm recent empirical evidence on price
effect of large and institutional trades found in the literature.
This paper is based on a chapter from the ﬁrst author’s dissertation at the University of Massachusetts-
Amherst. It was previously circulated under a different title.
M. K. Dey
University of Bridgeport, Bridgeport, CT, USA
M. K. Dey (&)
1091 Stillson Road, Fairﬁeld, CT 06824, USA
University of Massachusetts-Amherst, Amherst, MA, USA
Rev Quant Finan Acc (2008) 30:433–453