Relative performance of bid–ask spread estimators: Futures market evidence

The issue of transaction costs is the mainstay of the equity market microstructure. Research in the microstructure of futures markets has lagged behind. A primary reason is that futures exchanges in the U.S. do not record bid–ask quotes, requiring these costs to be imputed from transaction price data. A reliable estimator of bid–ask spreads would significantly enhance microstructure research in futures markets. Unique intraday data from the Sydney Futures Exchange (SFE) that include both transaction prices and bid–ask spreads allow us to compare bid–ask spread estimation techniques proposed in the literature against the benchmark of actual spreads in a futures market, and thus identify the best-performing estimator. To maximize relevance, we impose all the constraints that apply in U.S. futures data to perform our estimations. We find that the four bid–ask spread estimators considered significantly underestimate the actual spreads. However, simple moments-based estimators perform better in predicting spreads.     

The Components of the Bid‐Ask Spread: the Case of the Athens Stock Exchange

We analyse the components of the bid‐ask spread in the Athens Stock Exchange (ASE), which was recently characterised as a developed market. For large and medium capitalisation stocks, we estimate the adverse selection and the order handling component of the spreads as well as the probability of a trade continuation on the same side of either the bid or the ask price, using the Madhavan et al. (1997) model. We extend it by incorporating the traded volume and we find that the adverse selection component exhibits U‐shape patterns, while the cost component pattern depends on the stock price. For high priced stocks, the usual U‐shape applies, while for low‐priced ones, it is an increasing function of time, mainly due to the order handling spread component. Furthermore, the expected price change and the liquidity adjustment to Value‐at‐Risk that is needed are higher in the low capitalisation stocks, while the most liquid stocks are the high priced ones. Moreover, by estimating the Madhavan et al. (1997) model for two distinct periods we explain why there are differences in the components of the bid‐ask spread.     

Share repurchase tender offers and bid–ask spreads

This paper examines the impact of share repurchase tender offers on the market microstructure. We find that there is a temporary reduction in the bid–ask spread, and a temporary increase in volume and quotation depth during the offer period. Our evidence suggests that the bid–ask spread is asymmetric during the offer period with the bid-side spread smaller than the ask-side spread. The temporary reduction in the spread around offers is consistent with the competing-market-maker hypothesis which predicts that the intensified competition for the market maker raises bid prices and narrows the spread asymmetrically during the offer period.     

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.     

Statistical Properties of the Roll Serial Covariance Bid/Ask Spread Estimator

Exact small sample population moments of the standard serial covariance and variance estimators are derived under the assumptions of the Roll bid/ask spread model. Noise explains why serial covariance estimates are often positive in annual samples of daily and weekly returns. Small sample estimator bias partially explains why weekly estimates are more negative than daily estimates. Noise causes the Roll spread estimator to be severely biased by Jensen's inequality. The French-Roll adjusted variance estimator is unbiased but noisy. Empirical tests confirm the major implications.     

A new methodology for studying intraday dynamics of Nikkei index futures using Markov chains

The empirical study of intraday patterns of stock trading volatilities and bid–ask spreads in the literature depends on assumptions of specific price generating process and may therefore not be robust to distributional assumptions. By creating discrete states that conform more naturally to the way prices are actually quoted in the derivatives and assets markets, we employ a new methodology of Markov chains for studying the intraday dynamics of derivative prices. We apply the method to study the intraday behavior of the Nikkei index futures prices, trading volumes, and spreads. We find some interesting results such as higher probabilities of transitions between larger volatilities at the opening and closing times. The volatility at lunch break is strikingly low. Contrary to most of the literature, the Nikkei intraday bid–ask spread does not show a U-shaped pattern. We offer some explanations.     

Arbitrage violations and implied valuations: the option market

The ideas presented in this paper are those of the authors and not necessarily reflect the views of the National bank of Canada. Both authors thank the National Bank of Canada and the SSHRC of Canada for their help. Thanks are also due to Professor Y. Tian for his comments, and for participating, together with students of the Financial Engineering program at York University, in the data preparation and the execution of the Matlab programs. In this paper, we propose a necessary and sufficient condition for bid and ask prices of European options to be free of arbitrage, and derive from it an efficient numerical methodology to determine its satisfaction by a given set of prices. If the bid and ask prices satisfy the no-arbitrage (NA) condition, our methodology produces a vector of NA prices that lie between the bid and ask prices. Otherwise, our methodology generates a vector of arbitrage-free prices that is as close as possible, in some sense, to the bid–ask strip. The arbitrage-free prices detected by our methodology render the commonly used practice of using mid-points and then ‘cleaning’ arbitrage from them as unnecessary. Moreover, a vector of ‘cleaned’ prices obtained from mid-point prices may be outside the bid–ask spread even in an arbitrage-free market and, hence, in this case will not be representative of the current market. A new procedure of estimating implied valuation operators is also suggested here. This procedure is rooted in the economic properties of put and call prices and is based on Phillips and Taylor's approximation of a convex function. This approach is superior to common estimation techniques in that it produces an analytical expression for the implied valuation operator and is not data intensive as some other studies. Empirical findings for the new methods are documented and their economic implications are discussed.     

The Illiquidity of Corporate Bonds

This paper examines the illiquidity of corporate bonds and its asset‐pricing implications. Using transactions data from 2003 to 2009, we show that the illiquidity in corporate bonds is substantial, significantly greater than what can be explained by bid–ask spreads. We establish a strong link between bond illiquidity and bond prices. In aggregate, changes in market‐level illiquidity explain a substantial part of the time variation in yield spreads of high‐rated (AAA through A) bonds, overshadowing the credit risk component. In the cross‐section, the bond‐level illiquidity measure explains individual bond yield spreads with large economic significance.     

END‐OF‐DAY PRICING IN THE U.S. TREASURY MARKET: A COMPARISON OF GovPX AND THE FEDERAL RESERVE BANK OF NEW YORK

We compare end‐of‐day indicative U.S. Treasury prices from GovPX and the Federal Reserve Bank of New York (FRBNY). We find that the two sources rarely quote identical prices, and differences are not simply due to noise or rounding. The average bid price differential is 2 cents for notes and bonds, but it is only ¹/₁₀ of 1 cent for bills. Bid‐ask spreads in both sources appear to be largely artificial and contain limited information. Finally, we find that the end‐of‐day indicative FRBNY bid prices are closer to true intraday GovPX market quotes than end‐of‐day indicative quotes provided by GovPX itself.     

The relevance of information and trading costs in explaining momentum profits: Evidence from optioned and non-optioned stocks

Considerable evidence from many countries suggests momentum strategies generate profits. These have been difficult to rationalise and evidence on the sources of such profitability is inconclusive. We utilise a sample of optioned stocks, characterised by high liquidity, high market capitalisation and fewer short sales constraints and compare results with control samples of non optioned stocks chosen on the basis of market value, turnover and bid–ask spread. The sample characteristics, and the fact that derivatives improve the impounding of information into prices, enable us to draw conclusions about the causes of momentum profits. While we find that short sales constraints are not the major driver of profitability and that most momentum profits disappear using two transactions costs measures of the bid–ask spread, one not previously used, the persistence of some momentum profits indicates that the market underreacts even to the most publicly available information.     

Information asymmetry of fair value accounting during the financial crisis

We examine whether US banks’ fair value net assets, measured according to the three-level hierarchy introduced in SFAS 157, are associated with information asymmetry during the 2008 financial crisis. Our results show that bid–ask spread, a proxy for information asymmetry, is positively associated with fair value net assets, and the degree of association is contingent upon the three-level hierarchy, with bid–ask spreads being lowest for Level 1 (the most transparent valuation inputs) and highest for Level 3 (the least observable). Also, there is some evidence that SFAS 157 led to a reduction in bid–ask spread, and we find that quarterly changes in Level 1 and Level 2 fair value net assets are significantly associated with changes in bid–ask spread in 2008 when the spread was rapidly rising, but not in 2009 when it was falling. Our findings suggest that the three-level hierarchy under SFAS 157 provides investors with useful information, and fair value is associated with uncertainty, as measured by bid–ask spread, before and during the financial crisis.     

Explaining the intra-day variation in the bid–ask spread in competitive dealership markets – A research note

There are many possible explanations for variation in the inside bid–ask spread during the trading day, including informed trading, price inelastic market demand, price discovery, statistical artefact and market concentration. Each of these explanations is examined for consistency with respect to both the inside and average bid–ask spread, observed both inside and outside the mandatory quote period in the London Stock Exchange.     

Effects of large shareholding on information asymmetry and stock liquidity

Prior studies, such as Claessens et al.’s [Claessens, S., Djankov, S., Fan, J., Lang, L., 2002. Disentangling the incentive and entrenchment effects of large shareholding. Journal of Finance 57, 2741–2771], suggest that deviation between ultimate control and ownership decreases firm value (due to the entrenchment effects of large shareholding). Using a sample of Canadian firms, we study the relation of ultimate control and ownership with an important dimension of stock liquidity – bid–ask spread. We find that stocks with greater deviations between ultimate control and ownership have a larger information asymmetry component of their bid–ask spread and wider bid–ask spread. Our results are consistent with the notion that the ultimate owners of these stocks may have selfish agendas. To increase the probability of the agendas being implemented, the firms may have poor information disclosure, resulting in poor stock liquidity.     

Are Options on Index Futures Profitable for Risk‐Averse Investors? Empirical Evidence

American options on the S&P 500 index futures that violate the stochastic dominance bounds of Constantinides and Perrakis (2009) from 1983 to 2006 are identified as potentially profitable trades. Call bid prices more frequently violate their upper bound than put bid prices do, while violations of the lower bounds by ask prices are infrequent. In out‐of‐sample tests of stochastic dominance, the writing of options that violate the upper bound increases the expected utility of any risk‐averse investor holding the market and cash, net of transaction costs and bid‐ask spreads. The results are economically significant and robust.     

Stochastic Volatilities and Correlations of Bond Yields

I develop an interest rate model with separate factors driving innovations in bond yields and their covariances. It features a flexible and tractable affine structure for bond covariances. Maximum likelihood estimation of the model with panel data on swaptions and discount bonds implies pricing errors for swaptions that are almost always lower than half of the bid–ask spread. Furthermore, market prices of interest rate caps do not deviate significantly from their no‐arbitrage values implied by the swaptions under the model. These findings support the conjectures of Collin‐Dufresne and Goldstein (2003) , Dai and Singleton (2003) , and Jagnnathan, Kaplin, and Sun (2003) .     

Information Asymmetry and Asset Prices: Evidence from the China Foreign Share Discount

We examine the effect of information asymmetry on equity prices in the local A‐ and foreign B‐share market in China. We construct measures of information asymmetry based on market microstructure models, and find that they explain a significant portion of cross‐sectional variation in B‐share discounts, even after controlling for other factors. On a univariate basis, the price impact measure and the adverse selection component of the bid‐ask spread in the A‐ and B‐share markets explains 44% and 46% of the variation in B‐share discounts. On a multivariate basis, both measures are far more statistically significant than any of the control variables.     

Optimal dealer pricing under transactions and return uncertainty

The paper examines the optimal behavior of a single dealer who is faced with a stochastic demand to trade (modeled by a continuous time Poisson jump process) and facing return risk on his stock and on the rest of his portfolio (modeled by diffusion processes). Using stochastic dynamic programming, we derive the optimal bid and ask prices that maximize the dealer's expected utility of terminal wealth as a function of the state in which he finds himself. The relationship of the bid and ask prices to inventory of the dealer, instantaneous variance of return, stochastic arrival of transactions and other variables is examined.     

The impact of the French Tobin tax

We analyze the impact of the introduction of the French Tobin tax on the turnover and measures of the liquidity and volatility of the affected stocks with nonparametric tests on individual stocks, difference-in-difference tests and other robustness checks controlling for simultaneous month-of-the-year and size effects. Our findings indicate that the tax produces a significant reduction in turnover and volatility (measured in terms of stock price volatility and the high–low price range) and inconclusive effects on liquidity when the latter is evaluated under the two dimensions of the estimated bid–ask spread and the Amihud (2002) price impact ratio.     

Central limit theorem for the realized volatility based on tick time sampling

A central limit theorem for the realized volatility estimator of the integrated volatility based on a specific random sampling scheme is proved, where prices are sampled with every ‘continued price change’ in bid or ask quotation data. The estimator is shown to be robust to market microstructure noise induced by price discreteness and bid–ask spreads. More general sampling schemes also are treated in case that the price process is a diffusion.     

Structural changes,bid–ask spread composition and tick size in inter-bank futures trading

This paper studies a period containing three major structural changes, which constitute a natural experiment in the NYSE.Euronext-LIFFE European short-term interest rate (STIR) futures market. These changes comprise (1) a 50% reduction in minimum tick size for the most heavily traded contract, (2) European Monetary Union and (3) the transition from open outcry to electronic trading. We analyse a number of microstructure features of the four largest European interest rate futures contracts throughout this period. In particular, we focus on bid–ask spread composition using a recent model which is appropriate for this market structure. Our analysis identifies the tick size as the largest bid–ask spread component in almost every instance, which suggests that participants in this STIR future market might benefit from a reduction in minimum tick sizes.