September 17, 2006
I posted on Harris’ discussion of spreads earlier. Harris goes on to summarise the main three spread determinants as asymmetric information, volatility and utilitarian trading interest. Utilitarian interest is trading by investors, hedgers and gamblers rather than market makers. Volatility can be measured, but the other two factors can’t.
When there is a high degree of asymmetry in trader information dealers will be hit by the adverse selection of the well informed traders. Consequently they’ll set spreads wide to recover the costs of adverse selection from uninformed traders.
Which makes me wonder how asymmetrical information can be in the fixed income rates world. I can imagine all kinds of asymmetry in the equity world, from insider knowledge to detailed sector research. But what is there to know about a straight government bond ? It’s principal, coupons and maturity. Given those we can calculate its present value. Of course, it’s not quite as simple as that, but my point is that there’s no potentially hidden information. This should lead to narrow spreads.