FRM Part II · FRM Exam Part II · Liquidity and Leverage
Which of the following changes would most likely be associated with a wider bid-ask spread in a market?
Higher inventory-holding and adverse-selection risk for market makers is linked to wider spreads, because dealers demand more compensation for holding risky positions and trading against informed counterparties. Competition, high volume and lower processing costs tend to narrow spreads.
- AHigher inventory-holding and adverse-selection risk faced by market makersCorrect
- BLarger numbers of competing market makers
- CHigher trading volume with low volatility
- DLower order-processing costs from automation
Explanation
Spreads compensate dealers for order processing, inventory risk and adverse selection. Higher inventory and information risk raise the spread, while competition, volume and lower processing costs narrow it.
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