Adverse selection costs, trading activity and liquidity in the NYSE: an empirical analysis in a dynamic context

Abstract

This paper measures the adverse selection costs associated to a given trade by estimating its permanent impact on market quotes. This estimation depends on observable trade features and market conditions, and it is given by the impulse-response function of a generalization of the Hasbrouck's (1991a,b) VAR model. It is evidenced that microstructure structural models of quote formation may introduce a downward bias in the estimation of adverse selection costs by assuming that trades only have an immediate impact on prices. Moreover, it is observed that the market behavior, in terms of liquidity and activity, in the short-term period after a trade depends on the information-asymmetry risk associated to that trade.