There are three principal determinants of the bid–ask spread: fixed costs, adverse selection costs and inventory costs. Fixed costs are order processing costs, such as administrative costs and compensation for the market-maker’s time. Adverse selection costs stem from asymmetric information. Finally, dealers must sustain the inventory costs of holding undesired portfolios of risky assets. By nature, only risk-averse dealers will be concerned with inventory costs, so the models that include them assume that liquidity providers are risk-averse. This assumption, which complicates the algebra, can be dispensed with in models with adverse selection.

The next two articles are dedicated to models that focus on the adverse selection component of the bid–ask spread. It will also discuss inventory and fixed costs. The model presented in this chapter draws on the work of Kyle (1985), who posits a group of risk-neutral market-makers facing insiders and liquidity traders. In fact, Kyle models the strategic interaction between an insider who chooses to trade in order to maximize his profits and a group of market-makers who take the insider’s strategy into account in updating their beliefs on the future value of the asset and setting the equilibrium price. In this way, Kyle shows how information is incorporated into prices and how the latter reflect both the trading protocol where market-makers set prices and the strategic behaviour of the informed trader.

Once you have searched the stores in your area as thoroughly as you possibly can and have convinced yourself that your idea is not currently being offered in the local stores, it is time to get online and begin an Internet market search. There are a couple of steps to be completed in this search in order to be thorough here and it will be a bit time-consuming, but it is not difficult. You will do a key word search and a catalog search. You will start your Internet search by making a list of key words that might be used to describe your invention. You will be searching through the links to see what products similar to your invention are being offered for sale on the Internet. Even if you feel strongly that no similar products exist, you will be surprised by what a key word search will turn up. Use the most descriptive words you can think of and get as specific as possible in the description. By this, we mean get right down to the most common descriptive words for your invention. For example, if your product is a kitchen gadget, it is far too broad to simply type in, “Kitchen Gadget.” This would bring up many more links than you would want, or need, to search. If the invention is designed for peeling grapes, say so. Type in, “Grape Peeler.” Then, as you begin to click on and follow the links that this brings up, you will find more words on those pages that will help you to reach even more links and get even more specific. For example, you may find words that are specific to that type of product – i.e. rind removal – that would lead you to entirely new links to explore.