Volatility and Liquidity
Much research has been devoted to modeling and forecasting the volatility of financial returns, and yet few theoretical models explain how volatility comes to exist in the first place.
Roll (1984) shows that volatility is affected by market microstructure. Glosten and Milgrom (1985) shows that at least one source of volatility can be explained by the liquidity provision process. When market makers infer the possibility of adverse selection, they adjust their trading ranges, which in turn increases the band of price oscillation.
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