Determinants of the components of bid-ask spreads on stocks

In this paper we show that George et al. (GKN, 1991) estimators of the adverse selection and order processing cost components of the bid-ask spread are biased due to intertemporal variations in the bid-ask spread. We use alternative estimators that correct this bias and that are applicable to individual securities, and estimate these cost components empirically using data on NYSE/AMEX stocks. As expected, our results indicate that on average adverse selection costs account for approximately 50% of the bid-ask spread, sharply higher than the estimates of 8-10% obtained by GKN for NASDAQ stocks and 21% that we obtain for NYSE/AMEX stocks using GKN's estimators. We then conduct cross-sectional regressions designed primarily to determine whether adverse selection costs vary across specialists after controlling for firm size and other factors. Consistent with previously established hypotheses, we find that adverse-selection costs vary across specialists, and that this variation is related to the number of securities that the specialist handles.     

Execution Costs of Institutional Equity Orders

We compare institutional execution costs across the major U.S. exchanges using a sample of institutional equity orders in firms that switch exchanges. Execution costs including commissions are essentially indistinguishable across these exchanges. We also find the fraction of trading volume from momentum traders is greater on the NYSE than on either the Nasdaq or AMEX and that orders are more likely to be worked by an institution's trading desk on the NYSE than on the Nasdaq. These results suggest that institutions actively manage execution strategies, taking into account characteristics of the markets in which they trade.Journal of Economic Literature Classification Numbers: G10, G19, G20, G23.     

Trading Mechanisms and the Components of the Bid-Ask Spread

We compare the relative magnitudes of the components of the bid-ask spread for New York Stock Exchange (NYSE)/American Stock Exchange (AMEX) stocks to those of National Association of Securities Dealers Automated Quotations (NASDAQ)/National Market System (NMS) stocks. We find that the order-processing cost component is smaller, and the adverse selection component is greater on the NYSE/AMEX trading systems than on the NASDAQ/NMS system. The inventory holding component is also greater for exchange-traded stocks than for NASDAQ/NMS stocks, but this may be attributable to differences in the characteristics of the firms whose stocks trade on the respective systems.     

Transaction costs and the small firm effect: A comment

Stoll and Whaley (1983) suggest large transaction costs may be responsible for the large risk-adjusted returns earned by small firm stocks. This study, using data from the AMEX as well as the NYSE, shows that investors can earn risk-adjusted excess returns after transaction costs by holding small firms for relatively short holding periods. Other literature that provides evidence that is inconsistent with the transaction costs hypothesis is cited.     

The Operating Performance of Firms that Switch Their Stock Listings

In this article we examine the operating performance of stocks that switch from NASDAQ to the American Stock Exchange (AMEX) or the New Stock Exchange (NYSE) and from AMEX to the NYSE. Specifically, we investigate whether post‐listing operating performance is consistent with the reported negative long‐term drift of post‐listing stock returns and whether there is evidence of self‐selection of the listing time. We find evidence of negative post‐listing changes in operating return on assets and sales, which, on a match‐adjusted basis, are significant for the relatively small NASDAQ stocks switching to AMEX. We also find evidence that firms self‐select the time of listing changes.     

RECENT GROWTH IN NASDAQ TRADING VOLUME AND ITS RELATION TO MARKET VOLATILITY

We document a significant increase in Nasdaq trading volume relative to New York Stock Exchange (NYSE) and American Stock Exchange (AMEX) trading volumes. Although recent increases in the number of shares traded are reported in the financial press, we also find it present in the percentage of dollar values traded. We then examine correlations between trading volume and several measures of market volatility. Nasdaq volume appears to be more closely correlated with residual variance, while NYSE and AMEX volumes are more closely correlated with overall market variance. We conclude that the type and quantity of information driving trading are different on Nasdaq than on the two exchanges, and that the relative growth in Nasdaq volume cannot be attributed solely to differences in the methods of counting volume in the two market environments.     

The Effect of Decimalization on Trade Size and Adverse Selection Costs

Abstract:   We examine adverse selection costs around NYSE decimalization. Further, we analyze the relation between adverse selection costs and trade size. We find a significant increase in the percentage adverse selection cost and a reduction in dollar adverse selection cost (percentage adverse selection multiplied by the spread) following complete decimalization on the NYSE. On estimating the adverse selection components by trade size classes, we find a decline in dollar adverse selection costs in trades of all sizes, with the strongest evidence coming from medium size trades, followed by small and large size trades. One implication of our findings is that there appears to be less stealth trading following complete decimalization and less institutional trading overall.     

Bid-Ask Spreads,Information Asymmetry,and Abnormal Investor Sentiment: Evidence from Closed-End Funds

Using a sample of closed-end equity funds listed on the NYSE from 1994 to 1999, we investigate differences in spreads and adverse selection costs between the closed-end funds and a matched sample of common stocks. We find that spreads and adverse selection costs for the closed-end funds are significantly lower than those of control stocks. The results are consistent for the subperiods both before and after the minimum tick size change on NYSE on June 24, 1997. The differences of spreads and adverse selection costs cannot be attributed to the differences in the characteristics of the closed-end funds and the matched sample of common stocks. Lastly, we find that abnormal investor sentiment and adverse selection costs of closed-end funds are positively correlated over time.     

Adverse selection costs for NASDAQ and NYSE after decimalization

NYSE and NASDAQ completed their decimalization on January 29, 2001 and on April 9, 2001 respectively. In this paper, we compare adverse selection component of the bid–ask spread for NASDAQ and NYSE stocks after decimalization using the data from May 2001 and July 2001. We find that the adverse selection component of the bid–ask spread is significantly lower on NASDAQ than on NYSE, and these differences cannot be attributed to the differences in the characteristics of the stocks traded in the two markets. In addition, we find that the adverse selection costs increase with trade size on NYSE, however there is no monotonic pattern observed for NASDAQ stocks. Lastly, we report that although the order flows arrived in the two markets are significantly different, they can at best explain a small portion of the observed differences in adverse selection costs.     

The Post-Merger Performance of Acquiring Firms: A Re-examination of an Anomaly

The existing literature on the post-merger performance of acquiring firms is divided. We re-examine this issue, using a nearly exhaustive sample of mergers between NYSE acquirers and NYSE/AMEX targets. We find that stockholders of acquiring firms suffer a statistically significant loss of about 10% over the five-year post-merger period, a result robust to various specifications. Our evidence suggests that neither the firm size effect nor beta estimation problems are the cause of the negative post-merger returns. We examine whether this result is caused by a slow adjustment of the market to the merger event. Our results do not seem consistent with this hypothesis.     

Trade size and components of the bid-ask spread

The relation between theorized components of the bid-ask spreadand trade size for a sample of NYSE firms is examined. We findthat the adverse selection component increases uniformly withtrade size. Conversely, order processing costs decrease withincreased in trade size for all but the largest trades. We findthat order persistence decreases with trade size. The adverseselection component is highest at the beginning of the day andlowest at the end of the day for all but the largest trades.Trades of NYSE firms executed on regional exchanges or NASDAQcontain a large order processing cost component but no significantadverse information effect.     

Does Idiosyncratic Risk Really Matter?

Goyal and Santa‐Clara (2003) find a significantly positive relation between the equal‐weighted average stock volatility and the value‐weighted portfolio returns on the NYSE/AMEX/Nasdaq stocks for the period of 1963:08 to 1999:12. We show that this result is driven by small stocks traded on the Nasdaq, and is in part due to a liquidity premium. In addition, their result does not hold for the extended sample of 1963:08 to 2001:12 and for the NYSE/AMEX and NYSE stocks. More importantly, we find no evidence of a significant link between the value‐weighted portfolio returns and the median and value‐weighted average stock volatility.     

Liquidity Provision and the Organizational Form of NYSE Specialist Firms

We examine the influence of NYSE specialist firm organizational form on the nature of liquidity provision. We compare closely held firms whose specialists provide liquidity with their own capital to widely held firms whose specialists provide liquidity with diffusely owned capital. We argue that specialists using their own capital have a greater incentive and ability to reduce adverse selection costs, but face a greater cost of capital. Differences in the proportion of spreads due to adverse selection costs, large trade frequency, the sensitivity between depth and spreads, and price stabilization support this argument.     

UNLISTED TRADING PRIVILEGES,LIQUIDITY, AND STOCK RETURNS

In this study we examine the effect of dual trading through unlisted trading privileges (UTPs) on liquidity and stock returns. Stocks with UTPs trade in a different market structure than stocks listed and traded only on the AMEX and NYSE. Differences in market structure may affect stock returns through liquidity services provided by the competing markets. The sample comprises 852 AMEX and NYSE firms that began unlisted trading on the Philadelphia, Pacific, Midwest, or Cincinnati exchanges between 1984 and 1988. The results show significantly positive abnormal returns around the SEC's announcement of a regional exchange's filing for UTPs. The results also suggest that increased competition improves trading liquidity. Only stocks with low liquidity before UTPs announcements experience significantly improved liquidity and positive stock returns.     

The Impact of the Reduction in Tick Increments in Major U.S. Markets on Spreads,Depth, and Volatility

This study presents an analysis of the impact of the introduction of quotes in sixteenths of a dollar on the AMEX, Nasdaq, and NYSE in mid-1997 on select market characteristics such as spreads, effective spreads, quoted depth, and volume. The findings of the study document reductions in the bid-ask spread, effective spread, and a statistically significant increase in the number of quotes. Interestingly, we find that liquidity, as measured by the total depth at the bid and ask, declines significantly on the AMEX and NYSE, but increases on the Nasdaq. Trading volume increases on the NYSE, but remains unchanged for the AMEX and Nasdaq. We also find that the proportion of even-increment quotes is a relevant factor affecting percentage spreads for Nasdaq both before and after and for the NYSE only after the change in quoting increments.     

EXCHANGE LISTINGS AND DELISTINGS: THE ROLE OF INSIDER INFORMATION AND INSIDER TRADING

We examine whether insiders systematically exploit their private information before exchange listings and delistings they are likely to know about before outsiders/investors. Analyzing a comprehensive sample of over-the-counter (OTC) firms, which listed on the New York Stock Exchange (NYSE) or American Stock Exchange (AMEX) during 1977–93, we find evidence that insiders act on their private information of an impending exchange listing by purchasing or postponing the sale of stock on private account. For firms delisting from the NYSE or AMEX, we find that insiders of these firms sell stock on private account before delisting. Overall, the evidence indicates that insiders act on their private information before exchange listings and delistings.     

Post-listing underperformance: Is it really bad to move trading locations?

We reexamine the post-listing puzzle by studying the stock performance of 2103 firms that moved from NASDAQ to NYSE or AMEX, or from AMEX to NYSE during 1973–1999. The matched four-factor regressions demonstrate that the listing firms do not underperform. Size-and-book-to-market matched factor regression finds that the “post-listing drift” is confined to the small set of firms moving from NASDAQ to AMEX during 1981–1990, within size deciles 3–6 and book-to-market quintiles 1–3. A further control of the industry effect is able to resolve the remaining abnormal returns. Our results are consistent with the pseudo market timing hypothesis in Schultz, (2003) [Schultz, P., 2003. Pseudo market timing and the long-run underperformance of IPOs. J. Fin. 58, 483–517.].     

SECURITY RETURN DISTRIBUTIONS AND MARKET STRUCTURE: EVIDENCE FROM THE NYSE/AMEX AND THE NASDAQ MARKETS

This paper documents significant and persistent deviations from normality in security return distributions for the NYSE, AMEX, and NASDAQ from 1974 to 1988. Controlling for January and size effects, we find that the deviations of security return distributions from normality decline with increasing portfolio size and investment horizon for the NYSE and AMEX, especially for daily returns. Deviations appear to be greater for the NASDAQ than for the two exchanges even for firms of the same size. Ratios of monthly to daily variances are also larger for the NASDAQ. These results suggest that nonparametric or other robust statistical techniques should be used when valuing equity options and other derivatives, especially when examining NASDAQ security returns. They further imply that trading strategies based on market inefficiencies are more likely to succeed on the NASDAQ.     

Stock Splits, Tick Size, and Sponsorship

A traditional explanation for stock splits is that they increase the number of small shareholders who own the stock. A possible reason for the increase is that the minimum bid-ask spread is wider after a split and brokers have more incentive to promote a stock. I document a large number of small buy orders following Nasdaq and NYSE/AMEX splits during 1993 to 1994. I also find strong evidence that trading costs increase, and weak evidence that costs of market making decline following splits. This is consistent with splits acting as an incentive to brokers to promote stocks.     

Specialists,Limit‐Order Traders,and the Components of the Bid‐Ask Spread

This study compares the components of the bid‐ask spread estimated from quotes that reflect the trading interest of specialists with those estimated from limit‐order quotes and all available quotes for a sample of New York Stock Exchange (NYSE) stocks. The results show that the adverse selection component of the spread estimated from specialist quotes is significantly smaller than the corresponding figures from limit‐order quotes and entire quotes. We interpret this as evidence that NYSE specialists transfer at least a part of adverse selection costs to outsiders through the discretionary use of limit orders. Our results show that the estimation/interpretation of the components of the spread using quote data that include both specialist and limit‐order interests is problematic.