The components of the bid-ask spread: a general approach

A simple time-series market microstructure model is constructedwithin which existing models of spread components are reconciled.We show that existing models fail to decompose the spread intoall its components. Two alternative extensions of the simplemodel are developed to identify all the components of the spreadand to estimate the spread at which trades occur. The empiricalresults support the presence of a large order processing componentand smaller, albeit significant, adverse selection and inventorycomponents. The spread components differ significantly accordingto trade size and are also sensitive to assumptions about therelation between orders and trades.     

Asset pricing and the bid-ask spread

This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.     

Estimating bid-ask spread components: Specialist versus multiple market maker systems

This paper tests two competing hypotheses concerning the relationship between adverse selection costs on NASDAQ versus specialist-dominated exchanges. We reject the hypothesis that specialist-dominated exchanges have smaller adverse selection costs than exchanges with multiple market makers. We provide direct evidence on the timing differences between closing transactions and quotes as well as evidence on the extent of nontrading on the AMEX and NYSE but cannot reject the hypothesis that adverse selection costs are a function of average transaction size (which is generally larger on the AMEX and NYSE). We also provide insight into institutional differences across exchanges and the ISSM data base.     

Entry, exit, market makers, and the bid-ask spread

The probability of entry and exit of dealers on the NASDAQ NationalMarket (NNM) is significantly affected by trading intensity,volatility and the quoted bid-ask spread. Entry and exit ofmarket makers is a pervasive phenomenon. Large-scale entry (exit)is associated with substantial declines (increases) in quotedend-of-day inside spreads, even after controlling for the effectsof changes in volume and volatility. The spread changes arelarger in magnitude for issues with few market makers; however,even for issues with a large number of market makers, substantialchanges in quoted spreads take place. The results are consistentwith the competitive model of dealer pricing.     

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.     

Estimation of the effective bid-ask spread on high frequency Danish bond data

In this paper the effective bid-ask spread is estimated using 12 high frequency Danish bond samples. A clear-cut MA(1)-model for the mean of the return series, and a GARCH(1,1)-model for the variance, are found. Basically, Roll's model is used, but three different methods of calculating the first-order autocovariance are suggested. Each of these in turn produces three possible ways of estimating the effective bid-ask spread. First, Roll's original autocovariance estimate is used. Second, the autocovariance is calculating using the parameters of an estimated MA(1) model. Third, the autocovariance is obtained from the parameters of a joint MA(1)-GARCH(1,1) model. By means of bootstrapping the standard error of the bid-ask spread estimates are found. It is shown that the gain in efficiency, measured by the relative difference in the standard error of the estimates, is 29% when going from method one to method two, but only 1% when going from method two to method three. These results indicate that the extra gain in efficiency obtained by taking account of the MA(1) structure of the data is noteworthy, but the gain when incorporating the GARCH-effects is negligible.     

Currency bid-ask spread dynamics and the Asian crisis: Evidence across currency regimes

Using a sample of 21 emerging and developed country currencies, we evaluate the impact of the Asian crisis on bid-ask spreads. While the crisis had widespread and uniform volatility effects, the spread effects were not uniform across emerging and developed country currencies. For Asian emerging markets, spreads widened and spread volatility increased significantly during the crisis, while developed markets spreads narrowed and spread volatility decreased significantly. We investigate the impact of more flexible and less flexible exchange rate regimes on bid-ask spreads using panel data. In general, countries with tightly-managed regimes have significantly lower spreads than countries with more freely-floating regimes, while controlling for the influence of other factors such as volatility. Asian developing market spreads are higher than spreads of the other countries, again, after controlling for the influence of other factors.     

Optimal mean-reversion strategy in the presence of bid-ask spread and delays in capital allocations

A portfolio optimization problem for an investor who trades T-bills and a mean-reverting stock in the presence of proportional and convex transaction costs is considered. The proportional transaction cost represents a bid-ask spread, while the convex transaction cost is used to model delays in capital allocations. I utilize the historical bid-ask spread in US stock market and assume that the stock reverts on yearly basis, while an investor follows monthly changes in the stock price. It is found that proportional transaction cost has a relatively weak effect on the expected return and the Sharpe ratio of the investor's portfolio. Meantime, the presence of delays in capital allocations has a dramatic impact on the expected return and the Sharpe ratio of the investor's portfolio. I also find the robust optimal strategy in the presence of model uncertainty and show that the latter increases the effective risk aversion of the investor and makes her view the stock as more risky.     

Order flow, bid-ask spread and trading density in foreign exchange markets

This paper examines the implications of market microstructure for foreign exchange markets. We argue that the usual order flow model needs to be recast in broader terms to incorporate the transaction costs of liquidity and the limitation of price discovery through order flows that involve low trading density currencies. Using a daily data set, we find that order flows are inadequate when it comes to explaining the changes in the low trading density currencies. Alternatively, within the high trading density, both order flows and bid-ask spreads significantly affect the foreign exchange rate returns. Our findings suggest that the order flow model is better at incorporating these microstructure effects except for some currencies with a very high level of trading density.     

Estimating the bid-ask spread in a heteroskedastic market: The case of foreign currency futures

Because the bid-ask spread often defies direct measurement, a serial covariance-based approach is frequently used to estimate it. We develop a new serial covariance estimator that exploits the relation of time-varying volatility to trading activity to obtain more precise estimates. The performance of Roll's (1984) estimator and the new estimator are compared using intraday data for four foreign currency futures. The new estimator finds currency futures spreads to be of economic significance—usually two to three ticks, or $25.00 to $37.50 per contract. A distinct maturity effect is present, with the lowest spreads occurring one to three months from expiration. While no evidence is found that the intraday spread changes near closing, the spread is larger near opening for some contracts four to six months from expiration.The University of Texas at Austin. We appreciate the comments of Katherine Daigle, Scott Irwin, Dan Quan, Barry Schachter, workshop participants at the University of Houston, and three anonymous referees. Part of this work was completed while Laux was visiting the Commodity Futures Trading Commission, and the support of the Commission is appreciated.     

The no-arbitrage condition and financial markets with transaction costs and heterogeneous information: The bid-ask spread

This paper investigates the implications of the no-arbitrage (NA) condition in markets with transaction costs and heterogeneous information. Dermody and Prisman (1993) showed that, in financial markets with increasing marginal transaction costs, the NA condition is equivalent to the existence of a valuation operator. They explore the exact dependence of this operator on the structure of transaction costs. They show that equilibrium prices in the “corresponding” perfect markets plus a certain factor determine the valuation operator in markets with increasing marginal transaction costs. This paper emphasizes that their result is applicable to financial markets with decreasing marginal transaction costs. Furthermore, this paper shows that, in financial markets with transaction costs and heterogeneous information, the NA condition imposes a constraint on the bid-ask spread.     

Asymmetric information and the bid-ask spread: an empirical comparison between automated order execution and open outcry auction

This study examines the components of the bid-ask spread on the Sydney Futures Exchange. The Exchange uses open outcry auction for daytime trading, and switches to a screen-based automated order execution system at 16:30 h for overnight trading. After controlling for proxies of order flow characteristics, the study finds that screen-based traders are more sensitive to market volatility than floor-based traders in setting the bid-ask spread. Spreads from floor trading have a smaller adverse information component but a larger order processing cost component relative to screen trading. The results suggest that floor traders can better assess the presence of adverse information than screen traders.     

Penny pricing and the components of spread and depth changes

Recent studies show that decimal pricing led to significant reductions in the spread and depth on the NYSE. In this paper, we examine how the observed changes in the spread and depth can be attributed to different factors. We show that stocks with higher proportions of one-tick spreads and odd-sixteenth quotes, and more frequent trading before decimalization experienced larger declines in the spread and depth afterwards. We interpret this result as evidence of reduced binding constraints and increased price competition under decimal pricing. We also find that decimal pricing led to nontrivial changes in select stock attributes, and that these changes exerted an additional impact on spreads and depths. Our results suggest that sub-penny pricing may further reduce the spreads of high-volume, low-risk, or low-price stocks.     

Market changes and spread components,implications for international markets

Trading in international markets is changing and evolving due to competitive pressure and technological innovations. Evidence of changes are seen on the London Stock Exchange, Amsterdam Stock Exchange, the Swiss Exchange, and the Deutsche Borse. This paper examines changes in the components of Nasdaq spreads following the implementation of new Order Handling Rules in early 1997 and the reduction in minimum tick size from $0.125 to $0.0625 in June 1997. Trading volume increases and spreads decrease significantly following each change. We find that order processing and asymmetric information costs decline following each rule change. Inventory holding costs increase over the sample period. Also, we find a significant increase in the probability of a trade flow reversal after the implementation of the Order Handling Rules.     

Explaining co-movements between equity and CDS bid-ask spreads

In this paper I show that the co-movements between bid-ask spreads of equities and credit default swaps vary over time and increase over crisis periods. The co-movements are strongly related to systematic risk factors and to the theoretical debt-to-equity hedge ratio. I document that hedging and asymmetric information, besides higher funding costs and market volatility risk, are driving factors of the commonality and are significantly priced in CDS bid-ask spreads.     

Currency volatility and bid-ask spreads of ADRs and local shares

This paper examines the impact of currency volatilities on the average monthly spreads in ADRs and their underlying local shares. We employ a novel estimator for spreads based on two-day-period high and low values of a comprehensive universe of stocks over fifteen years using dynamic panel data estimation. Surprisingly, we find that currency volatility has a larger impact on spreads of ADRs than on their underlying local shares. This adds novel information to the well-documented evidence that local shares and exchange rate variations are the primary drivers of ADR returns. FX implied volatility accounts for about 16.6% of the variance in our sample. We also observe that, on average, ADR spreads are smaller than the spreads on their corresponding underlying shares. We posit that size matters and therefore provide measures of the economic significance of all our estimated results.     

Estimation of the bid - ask spread and its components: a new approach

We show that time variation in expected returns and/or partialprice adjustments lead to a downward bias in previous estimatorsof both the spread and its components. We introduce a new approachthat provides unbiased and efficient estimators of the componentsof the spread. We find that between 77 and 97 percent of thedownward bias in previous spread estimate is caused by timevariation in expected returns. More importantly, the adverse-selectioncomponent, though significant, accounts for a much smaller proportion(8 to 13 percent) of the quoted spread, at least for small trades,than the proportion (over 40 percent) previously reported inthe literature. Order processing costs are the predominant componentof quoted spreads.     

Trade size clustering and the cost of trading at the London Stock Exchange

For the London Stock Exchange, this paper investigates differences in trading costs between market maker (off-book) and order book trades, in the context of clustering in trade sizes and prices. We report several substantial findings. Even after controlling for differences in trade size, the realised spread measure is lower for off-book trades. For the order book, trade size clustering is not associated with differences in transaction costs nor with differences in the information content of trades. For the off-book market, trades in clustered (popular) sizes carry significantly more information than non-clustered trades. Despite the significant differences in the price impact estimates between the order book and off-book, we show that traders placing large orders off-book are still better off than trading via the order book as they benefit from a large discount from the current midpoint price. Additionally, we highlight that price and size clustering tend to occur simultaneously rather than being substitutes in this market setting.     

Market structure and bid-ask spreads: IBIS vs Nasdaq

A comparison is made between the bid-ask spreads of 30 high volume German stocks traded on IBIS and 30 high volume US stocks traded on Nasdaq. IBIS and Nasdaq are best described as agency and dealer auction markets, respectively. On average, the market spread for these IBIS and Nasdaq stocks is the same, but for the 10 most active stocks in each market, IBIS spreads are considerably lower. For these latter stocks, IBIS spreads change in a predictable manner throughout the day. Nasdaq spreads do not. The critical factor appears to be the unrestricted access of suppliers of immediacy that is distinctive for agency auction markets.