When the specialist offsets the losses from trades with information-motivated traders with gains from liquidity-motivated traders by widening the bid-ask spread, the specialist is said to be coping with the _______ problem.
A) moral hazard
B) liquidity-trap
C) index arbitrage
D) adverse selection

Question

Quizplus · Accepted Answer

The specialist is coping with the adverse selection problem, which occurs when traders with better information trade with less informed traders. By widening the bid-ask spread, the specialist discourages information-motivated traders from trading, reducing adverse selection. This allows the specialist to offset the losses from these traders with gains from liquidity-motivated traders. Moral hazard refers to the situation where one party may take more risks because another party will bear the costs of those risks. A liquidity-trap occurs when monetary policy becomes ineffective because interest rates are close to zero. Index arbitrage involves profiting from discrepancies between the value of a stock index futures contract and the value of the stocks that make up the index.

When the Specialist Offsets the Losses from Trades with Information-Motivated