The EKOP Model of Informed Trading and Bid-Ask Spreads
Summary
This note introduces the Easley, Kiefer, O’Hara, and Paperman (EKOP) model to explain how informed and uninformed trading can shape a stock’s bid-ask spread. It describes a discrete-day, continuous-within-day setting in which information events may be good or bad, a risk-neutral market maker posts quotes, informed traders act only when information arrives, and uninformed traders submit buys and sells regardless of news. Trade arrivals are modeled as independent Poisson processes.
The market maker uses Bayes’ rule to update the probabilities of good news, bad news, or no news after observing a buy or sell, then sets quotes from the resulting expected value. The note derives the intuition that a sell raises the estimated likelihood of bad news and that greater uninformed order flow can narrow spreads, while a market with only informed traders may have little or no viable trading. The displayed equations are missing from the text, and this is an introductory account of the model’s assumptions rather than an empirical test or a complete treatment of its applications.
Key ideas
- The EKOP model distinguishes informed traders, uninformed traders, and a risk-neutral market maker.
- Information events can raise or lower a stock’s value, while some trading days have no event.
- The market maker updates beliefs about news using observed order arrivals and Bayes’ rule.
- Quote prices reflect the market maker’s posterior expected value after observing order flow.
- A larger share of uninformed trading can reduce the adverse-selection component of the spread.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.