Questions: Market Maker Economics and Bid-Ask Spreads

Question 1

Stock A has 80% uninformed liquidity traders and 20% informed traders. Stock B has 40% uninformed traders and 60% informed traders. All else equal, which stock has a wider bid-ask spread?

• A. Stock A, because more uninformed traders means more volume and higher order processing costs
• B. Stock B, because a higher fraction of informed traders raises the adverse selection cost the market maker must recover from uninformed trades
• C. Both stocks have identical spreads because market makers set prices based on fundamentals, not trader composition
• D. Stock A, because uninformed traders are harder to serve than informed traders

Answer: (B)

The adverse selection component of the spread is directly proportional to the fraction of informed traders and the magnitude of their information advantage. With 60% informed traders in Stock B, the market maker loses money more often on trades (informed traders only transact when they have an edge) and must widen the spread to recover those losses from the 40% uninformed trades. The Glosten-Milgrom model formalizes this: spreads are inversely related to the proportion of uninformed (liquidity) trading.

Question 2

Bid-ask spreads widen sharply around scheduled earnings announcements. Which component of the three-part spread model primarily explains this pattern?

• A. Order processing costs, because announcements increase trading volume and strain market-making infrastructure
• B. Inventory holding costs, because market makers accumulate large positions during announcement periods
• C. Adverse selection costs, because earnings announcements increase the fraction of informed traders relative to uninformed ones
• D. All three components increase equally during announcement periods

Answer: (C)

Earnings announcements are scheduled information events: traders with superior research or information know (or strongly suspect) whether results will beat or miss consensus before the market maker does. The fraction of informed traders rises sharply, increasing the adverse selection risk the market maker faces on every trade. Order processing and inventory costs may shift, but the dominant explanation is adverse selection — the same reason spreads widen around central bank decisions, merger announcements, and other high-information events.

Question 3

The bid-ask spread represents pure profit for the market maker — it is compensation for a useful service with no genuine risk.

• T. True
• F. False

Answer: False

Market makers face real risks the spread must compensate. Adverse selection risk: informed traders systematically exploit the market maker's ignorance of true value, so the market maker loses money on every trade with an informed counterparty and must earn it back from uninformed traders. Inventory risk: when order flow is imbalanced, the market maker accumulates unwanted positions exposed to price movements. A market maker setting too narrow a spread is picked off by informed traders and loses money; too wide a spread drives away uninformed order flow. The spread is compensation for bearing genuine economic risks.

Question 4

Informed traders widen bid-ask spreads by raising the adverse selection costs that market makers must recover through the spread.

• T. True
• F. False

Answer: True

This is a core result of market microstructure theory. Informed traders transact specifically because they know the true asset value exceeds the ask (to buy) or is below the bid (to sell) — the market maker is always on the wrong side of informed trades. Since market makers cannot distinguish informed from uninformed traders, they must widen the spread so that profits from uninformed trades cover losses from informed trades. A higher fraction of informed traders mechanically requires a wider spread for the market maker to break even.

Question 5

Why must a market maker earn money from uninformed (liquidity) traders in order to survive, even if it consistently loses money on trades with informed traders?

Model answer: Market makers cannot distinguish informed traders from uninformed ones at the time of a trade. Informed traders buy when the true value exceeds the ask and sell when the true value is below the bid — the market maker is systematically on the losing side of every informed trade. If only informed traders existed, the market maker would lose money on every transaction. The only counterweight is uninformed liquidity traders (those buying or selling for portfolio rebalancing, cash needs, etc.) who have no information edge. The spread is set wide enough that profits from these uninformed trades exceed losses from informed trades.

The Glosten-Milgrom model formalizes this: the equilibrium spread equals twice the expected loss per unit traded with an informed counterparty. Market makers survive by cross-subsidization — uninformed traders effectively subsidize informed traders through the spread, and market makers extract enough from uninformed flow to cover the adverse selection losses. This is why spreads widen when uninformed trading volume falls: each remaining uninformed trade must subsidize more adverse selection losses.