Bid–ask spread

Abstract: This paper evaluates alternative methods for classifying individual trades as market buy or market sell orders using intraday trade and quote data. We document two potential problems with quote-based methods of trade classification: quotes may be recorded ahead of trades that triggered them, and trades inside the spread are not readily classifiable. These problems are analyzed in the context of the interaction between exchange floor agents. We then propose and test relatively simple procedures for improving trade classifications. THE INCREASING AVAILABILITY OF intraday trade and quote data is opening new frontiers for financial market research. The improved ability to discern whether a trade was a buy order or a sell order is of particular importance. In Hasbrouck (1988), the classification of trades as buys or sells is used to test asymmetric-information and inventory-control theories of specialist behavior. In Blume, MacKinlay, and Terker (1989), a buy-sell classification is used to measure order imbalance in tests of breakdowns in the linkage between S&P stocks and non-S&P stocks during the crash of October, 1987. In Harris (1989), an increase in the ratio of buys to sells is used to explain the anomalous behavior of closing prices. In Lee (1990), the imbalance in buy-sell orders is used to measure the market response to an information event. In Holthausen, Leftwich, and Mayers (1987), a buy-sell classification is used to examine the differential effect of buyer-initiated and seller-initiated block trades. Most past studies have classified trades as buys or sells by comparing the trade price to the quote prices in effect at the time of the trade. In this paper, we identify two serious potential problems with this method, namely, that quotes are often recorded ahead of the trade that triggered them, and that

Abstract: In an efficient market, the fundamental value of a security fluctuates randomly. However, trading costs induce negative serial dependence in successive observed market price changes. In fact, given market efficiency, the effective bid-ask spread can be measured by Spread=2−cov where “cov” is the first-order serial covariance of price changes. This implicit measure of the bid-ask spread is derived formally and is shown empirically to be closely related to firm size.

Abstract: Abstract 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.