Does adverse selection affect bid-ask spreads for options?

This study examines two different option markets to test whether differences in the level of adverse selection faced by market makers affect the size of bid-ask spreads. The data are from bank-issued options that trade on EuWax, where market makers face little adverse selection and traditional options that trade on EuRex. The results support the hypothesis that the adverse selection component of the bid-ask spread is important, as options on EuWax have lower bid-ask spreads than comparable options on EuRex. The results show that the adverse selection component represents at least half of the overall bid-ask spreads on the traditional EuRex. (c) 2008 Wiley Periodicals, Inc.