Intra Day Bid‐Ask Spreads, Trading Volume and Volatility: Recent Empirical Evidence from the London Stock Exchange

With the benefit of very high frequency (25 million 1 minute observations) and recent data (2001) for the UK, this paper explores a number of intra day patterns of stock market behaviour. More specifically, a distinct reverse J shaped bid‐ask spread pattern is noted for SETS securities, a declining bid‐ask spread pattern for non‐SETS securities, a two hump pattern for trading volume and a U‐shaped pattern for returns volatility for all securities. In terms of complementing the existing literature, the paper shows that differences in trading systems may affect the bid‐ask spread patterns, while differences in market environments (i.e. US and UK markets) seems to affect the trading volume pattern. The paper suggests avenues for future research, in particular, the need to consider what factors are significant in determining intra day patterns for different trading systems and the need for additional cross‐market comparisons to identify how institutional factors affect the behaviour of investors on an intra day basis.     

What Explains the Bid‐Ask Spread Decline after Nasdaq Reforms?

This paper examines whether the decrease in bid‐ask spreads on Nasdaq after the 1997 reforms is due to a decrease in market‐making costs and/or an increase in market competition for order flows. Unlike previous studies, we jointly examine how competition and trading costs affect bid‐ask spreads. In addition, we separate the effects of informed trading and liquidity costs on bid‐ask spreads. Informed trading cost is directly estimated for each Nasdaq stock using a Bayesian theoretic model. Empirical results show that market‐making costs and competition significantly affect bid‐ask spreads. The post‐reform decrease in bid‐ask spreads is largely due to both an increase in competition and a decrease in informed trading and liquidity costs on Nasdaq.     

The Impact of Mandated Cash Flow Disclosure on Bid‐Ask Spreads

Abstract:   This study provides evidence that mandatory cash flow disclosure required by Approved Australian Accounting Standard AASB 1026, Statement of Cash Flows (June 1992) was associated with a decline in bid‐ask spreads following the introduction of the regulation, even after controlling for changes in trading volume and price volatility. More pronounced decreases in bid‐ask spreads were associated with firms having lower correlations between reported CFO and estimates of CFO using balance sheet reconstructions. We conclude that mandatory cash flow disclosure reduces information asymmetry across market participants.     

Relationship Between Analyst Forecast Properties and Equity Bid‐Ask Spreads and Depths Around Quarterly Earnings Announcements

Abstract:   We study the relationships between three variables which proxy for the ex‐ante level of information asymmetry – forecast dispersion, forecast revision volatility, and the level of analyst coverage, and equity bid‐ask spread and depth changes around quarterly earnings releases. Kim and Verrecchia (1994) suggest that earnings releases increase the level of information asymmetry and lower the level of liquidity in the security market. Using both an OLS regression framework and a simultaneous equations model, we examine whether equity bid‐ask spreads increase and depths decrease as the level of information asymmetry increases. Our results indicate that spreads are higher (relative to a non‐event period) around earnings announcements when information asymmetry is more pronounced; however, depths are lower only on the day following the announcement when there is greater information asymmetry. Relative spreads have a significant positive relation with both forecast dispersion and revision volatility and a significant negative relation with analyst coverage. Relative depths have a significant negative relation with forecast dispersion and a significant positive relation with analyst coverage. Our findings indicate that the equity specialist adjusts both spreads and depths when confronting informed traders around earnings releases and that these adjustments are more pronounced when the level of information asymmetry is greater.     

The Opening, Short, Medium and Long Term Performance of Canadian Unit Trust Initial Public Offerings (IPOs)

Abstract:   This paper investigates the initial pricing and performance of Canadian unit trust IPOs over a three‐ to four‐year period and then draws implications for the efficiency of the Canadian market. Overall, the results confirm the following: in the short term, unit trust IPOs are underpriced and outperform the Canadian market; in the medium term, IPOs are fairly priced and neither outperform nor underperform the Canadian market; and in the long term, IPOs are fairly priced but underperform the Canadian market. In addition, our results confirm that the size of underpricing is related to ex‐ante uncertainty about the value of the issue. Ex‐ante uncertainty proxies, namely total risk, exchange listing, relative bid‐ask spread, and relative volume of initial trade, all explain the size of underpricing. When the effects of these factors are controlled, the results confirm that Canadian unit trust IPOs are indeed overpriced in the short term but underpriced in the long term. We conclude that the Canadian unit trust IPO market appears to be inefficient in the short and long term, but over the medium, the market appears to be efficient.     

Smiles, Bid‐ask Spreads and Option Pricing

Given the evidence provided by Longstaff (1995), and Peña, Rubio and Serna (1999) a serious candidate to explain the pronounced pattern of volatility estimates across exercise prices might be related to liquidity costs. Using all calls and puts transacted between 16:00 and 16:45 on the Spanish IBEX‐35 index futures from January 1994 to October 1998 we extend previous papers to study the influence of liquidity costs, as proxied by the relative bid‐ask spread, on the pricing of options. Surprisingly, alternative parametric option pricing models incorporating the bid‐ask spread seem to perform poorly relative to Black‐Scholes.     

Making a Market with Spreads and Depths

Abstract:   In this paper we study the quote revision behavior of NASDAQ market makers by analyzing inter‐temporal changes in their spread and depth quotes. Using individual dealer quote and trade data for a sample of 2,319 stocks, we find that NASDAQ dealers make more frequent revisions in depths than in spreads and the extent of liquidity management is greater for stocks of smaller companies, lower‐priced stocks, and stocks with larger trade sizes and fewer number of transactions. We show that intraday variation in the number of quote revisions follows the U‐shaped pattern, indicating that the extent of liquidity management is greater during the early and late hours of trading than during midday.     

Market Valuation of Successful versus Non‐successful R&D Efforts in the Pharmaceutical Industry

Abstract:   This paper examines the relationship between a non‐financial measure of successful research and development (R&D) efforts in the pharmaceutical industry and R&D expenditures. I hypothesize that the R&D of successful producers will be valued more by the market than the R&D of non‐successful producers. The regression results support the hypothesis. In the primary model, R&D is not associated with price; however, the coefficient on the interaction between R&D and successful developers is positively related to stock price. This implies that the market values the R&D expenditures of successful developers but not the expenditures of less‐successful developers.     

The Declining Role of NASDAQ Market Makers

We compare the liquidity providing behavior of NASDAQ market makers in 2010 to their behavior in 2004. We examine how frequently market makers are at the inside quote, what market and stock specific factors influence market makers’ behavior, and the relation between market maker participation and intraday bid‐ask spread patterns. We observe a decrease in the percent of the trading day dealers’ quote at the inside, a decline in the number of market makers, and a decrease in the influence market makers have on intraday spread patterns. The results suggest that the role of NASDAQ market makers declines over time.     

Bond Selection for Managed Portfolios

Abstract:   Investors in coupon bonds evaluate them based upon financial considerations such as coupon rate, time‐to‐maturity, callability, convertibility, and financial condition of the issuer. These investors regard promised yield as only a rough measure of the reward a bond offers to compensate them for the pure time‐value‐of‐money and the financial risks to which they are exposed. Hence, they need a more meaningful measure of reward to facilitate comparisons among coupon bonds. The purpose of this paper is to describe an alternative heuristic approach to the task of making such comparisons. The approach produces a simple ordinal measure of reward, called the 'indifference spread,' that considers implicitly the potential sources of return to, as well as many of the risks associated with, investment in coupon bonds. For any coupon bond, the indifference spread method permits assessment of relative reward offered for the combined exposures to price and call risks, while also reasonably accommodating possible sale anytime prior to maturity. Once an investor (e.g., money manager) identifies indifference spreads for all bonds under consideration as of any moment in time, he/she can then draw conclusions regarding their relative values at that time based, in large part, on these spreads.     

Tests of Weak‐Form Efficiency of the Dhaka Stock Exchange

Abstract:   Conflicting evidence on weak form efficiency of the Dhaka Stock Market appears to stem from the use of monthly versus daily data, structural changes after the 1996 market crash, and the use of tests with or without heteroscedasticity adjustment. Heteroscedasticity‐robust tests indicate short‐term predictability of share prices prior to the crash, but not afterwards. Although a heteroscedasticity‐robust Box‐Pierce test was used by Lo and MacKinlay (1989) in their simulations, our study appears to be the first to apply this test to stock prices. Typical rejection of weak‐form market efficiency by the usual autocorrelation tests may be reversed by a heteroscedasticity‐robust test.     

Regulation Fair Disclosure and the Cost of Adverse Selection

Regulation Fair Disclosure (FD), imposed by the Securities and Exchange Commission in October 2000, was designed to prohibit disclosure of material private information to selected market participants. The informational advantage such select participants gain is unclear. If multiple “insiders” receive identical information, private information is immediately incorporated in price and each insider has zero expected profit. If, on the other hand, Regulation FD has curtailed the flow of information from firms, private information becomes longer‐lived and more valuable. Hence, market makers will demand increased compensation by widening the adverse selection component of the bid‐ask spread. We identify the cost components of the bid‐ask spread for a sample of NASDAQ stocks surrounding the implementation of Regulation FD. Controlling for other factors affecting the spread, we find that adverse selection costs increase approximately 36% after Regulation FD. We interpret our finding as Regulation FD failing to achieve one of its desired objectives.     

The Relation Between Investor Uncertainty and Market Reactions to Earnings Announcements: Evidence from the Property‐Casualty Insurance Industry in the USA

Abstract:   This paper investigates the relationship between investor uncertainty, gauged by properties of analysts' forecasts, and the stock market response to earnings. We find that uncertainty is best characterized by a comprehensive measure recently proposed by Barron, Kim, Lim and Stevens (1998) , BKLS. The BKLS measure is related to uncertainty‐inducing events, as well as factors that affect the difficulty faced by analysts in forecasting earnings. We conclude that, first, pre‐disclosure uncertainty is a significant determinant of the price reaction to the earnings release, and second, BKLS is a more comprehensive measure of uncertainty than simple dispersion.     

An evolutionary multi‐objective optimization of trading rules in call markets

We evaluate an agent‐based model featuring near‐zero‐intelligence traders operating in a call market with a wide range of trading rules governing the determination of prices and which orders are executed, as well as a range of parameters regarding market intervention by market makers and the presence of informed traders. We optimize these trading rules using a multi‐objective population‐based incremental learning algorithm seeking to maximize the trading volume and minimize the bid–ask spread. Our results suggest that markets should choose a small tick size if concerns about the bid–ask spread are dominating and a large tick size if maximizing trading volume is the main aim. We also find that unless concerns about trading volume dominate, time priority is the optimal priority rule. Copyright © 2011 John Wiley & Sons, Ltd.     

The impact of aggressive orders in an order-driven market: a simulation approach

This article investigates resiliency in an order-driven market. On basis of a vector autoregressive model capturing various dimensions of liquidity and their interactions, I simulate the effect of a large liquidity shock, measured by a very aggressive market order. I show that, despite the absence of market makers, the market is resilient. All dimensions of liquidity (spread, depth at the best prices and order book imbalances) revert to their steady-state values within 15 orders after the shock. For prices, a long run effect is found. Furthermore, different dimensions of liquidity interact. Immediately after a liquidity shock, the spread becomes wider than in the steady state, implying that one dimension of liquidity deteriorates, while at the same time, depth at the best prices increases, meaning an improvement of another liquidity dimension. In subsequent periods, the spread reverts back to the steady-state level but also depth decreases. Also, I find evidence for asymmetries in the impact of shocks on the ask and bid side. Shocks on the ask side have a stronger impact than shocks on the bid side. Finally, resiliency is higher for less-frequently traded stocks and stocks with a larger relative tick size.     

The determinants of the price impact of block trades: further evidence

This article extends previous literature which examines the determinants of the price impact of block trades on the Australian Stock Exchange. As previous literature suggests that liquidity exhibits intraday patterns, we introduce time of day dummy variables to explore time dependencies in price impact. Following theoretical developments in previous literature, the explanatory power of the bid–ask spread, a lagged cumulative stock return variable and a refined measure of market returns are also examined. The model estimated explains approximately 29 per cent of the variation in price impact. Block trades executed in the first hour of trading experience the greatest price impact, while market conditions, lagged stock returns and bid–ask spreads are positively related to price impact. The bid–ask spread provides most of the explanatory power. This suggests that liquidity is the main driver of price impact.     

Related securities and price discovery: Evidence from NYSE-listed Non-U.S. stocks

In this paper we analyze whether handling related securities improves a market maker's information environment and helps to incorporate new information in stock prices. Our empirical tests are focused on New York Stock Exchange specialists and the U.S. share in price discovery of 64 British and French companies cross-listed on the NYSE. We define related securities as stocks from the same country, the same region, or other foreign stocks. We find strong evidence that a higher prominence of related stocks in the specialist portfolio is associated with a higher U.S. share in price discovery of our sample firms. We interpret our findings as evidence that concentrating market makers in similar stocks reduces information asymmetries and improves the information environment as market makers can extract information relevant to a stock from order flow to related securities. To support our argument, we show that the adverse selection component of the bid–ask spread is negatively related to the prominence of other foreign stocks in the specialist portfolio.     

Effect of the Actual Size Rule Under Market Stress

We examine the introduction of the Actual Size Rule (ASR) on Nasdaq during a control period and a period of market stress. We find that market makers in both ASR and Non-ASR stocks reduce quotation sizes and widen spreads when under stress but the reduction of quotation size and increase in spread width are significantly larger for ASR stocks. We also examine October 27, when the market was under the most severe stress. We find ASR and Non-ASR stocks have similar reductions in time-weighted quotation ask size when compared with the control sample but ASR bid sizes are about 10% smaller than Non-ASR bid sizes. Our findings imply that the ASR rule may significantly reduce market quality under times of market stress. JEL Classification: 14, G15, G18     

Net Present Value-Consistent Investment Criteria Based on Accruals: A Generalisation of the Residual Income‐Identity

Abstract:   In recent years, many firms have favoured residual income for value based management. One main argument for this measure is its identity with the net present value rule and that this compatibility with the net present value rule holds true for all possible depreciation schedules selected. In this article, we analyse whether there are other, undiscussed, accrual accounting numbers that enable net present value‐consistent investment decisions for all possible depreciation schedules. Our analysis provides an if‐and‐only‐if characterisation of the entire class of net present value‐consistent investment criteria, based on accounting information. This provides new insights into the residual income concept, hurdle rates, opening and closing error conditions achieved by applying more common performance measure structures, and allocation rules. Moreover, our analysis shows the limits of constructing such investment criteria.     

Modeling the bid/ask spread: measuring the inventory-holding premium

The need to understand and measure the determinants of market maker bid/ask spreads is crucial in evaluating the merits of competing market structures and the fairness of market maker rents. This study develops a simple, parsimonious model for the market maker's spread that accounts for the effects of price discreteness induced by minimum tick size, order-processing costs, inventory-holding costs, adverse selection, and competition. The inventory-holding and adverse selection cost components of spread are modeled as an option with a stochastic time to expiration. This inventory-holding premium embedded in the spread represents compensation for the price risk borne by the market maker while the security is held in inventory. The premium is partitioned in such a way that the inventory-holding and adverse selection cost components, as well as the probability of an informed trade, are identified. The model is tested empirically using Nasdaq stocks in three distinct minimum tick size regimes and is shown to perform well both in an absolute sense and relative to competing specifications.