Adverse Selection · Interview Question
Explain adverse selection / the winner's curse for a market maker. How should it change your quotes?
How to answer
When a counterparty lifts your offer, the asset is probably worth MORE than you thought; when they hit your bid, it's worth LESS. The people who trade against you are disproportionately the informed ones, so every fill drags your inventory the wrong way. Defense: widen your spread when counterparties may be informed, and update fair value toward the side that traded.
Key idea: Update on direction of the trade; widen against informed flow.
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