What are practical examples of adverse selection market makers have to deal with?? I’ve read books but couldn’t really understand the concepts…
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$\begingroup$ The risk is that the counterparty knows something that the market-maker does not yet know and is not reflected in the price (in the literature this is called an informed trader as opposed to a liquidity or noise trader). So he/she knows some news that is not yet well disseminated (it could be insider trading (illegal) but could also be someone who is at a press conference and getting information directly from the company, etc.). $\endgroup$– nbbo2Feb 15, 2022 at 17:30
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$\begingroup$ Thanks, how could that affect the price? And what market makers do to mitigate the effect? $\endgroup$– KmdFeb 15, 2022 at 17:33
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$\begingroup$ The mkt maker loses when he sells to an informed buyer or buys from an informed seller, he regrets the trade once the info becomes public.. The theoretical models say the greater the probability of adverse selection, the greater should be the bid-ask spread the market maker uses. A wide ba spread will compensate for some adverse selection the theoreticians say. $\endgroup$– nbbo2Feb 15, 2022 at 17:36
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$\begingroup$ Can the market maker price arbitrarily? Don’t they simply price based on NBBO? $\endgroup$– KmdFeb 15, 2022 at 17:55
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