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TL;DR

A situation where one party has superior information, causing the uninformed party to trade at a disadvantage. In market microstructure, informed traders systematically profit at the expense of market makers.

By Valenke Exam Prep Team·Last updated 2026-06-03

Adverse Selection

A situation where one party has superior information, causing the uninformed party to trade at a disadvantage. In market microstructure, informed traders systematically profit at the expense of market makers.

Why it matters for interviews

Adverse selection is the primary cost faced by market makers and the main driver of bid-ask spreads. Understanding the Glosten-Milgrom and Kyle models of adverse selection is essential for market microstructure interviews.

Definition and Mathematical Foundation

A situation where one party has superior information, causing the uninformed party to trade at a disadvantage. In market microstructure, informed traders systematically profit at the expense of market makers.

Application in Quantitative Finance

Adverse selection is the primary cost faced by market makers and the main driver of bid-ask spreads. Understanding the Glosten-Milgrom and Kyle models of adverse selection is essential for market microstructure interviews.

Related Terms

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Frequently Asked Questions

What is the Glosten-Milgrom model?▼
A sequential trade model where the market maker updates beliefs about the asset value after each trade. Buys suggest informed buying (value is high), asks suggest informed selling. The spread reflects the probability and information advantage of informed traders.
What is the Kyle model?▼
A model with a single informed trader, noise traders, and a competitive market maker. The informed trader strategically chooses order size to maximize profit. The equilibrium price impact is linear in order flow, and information is gradually incorporated into prices.
How is adverse selection measured empirically?▼
Common measures include the VPIN (Volume-Synchronized Probability of Informed Trading), the effective spread decomposition (realized spread vs. price impact), and the order flow toxicity metric.