Modeling the bid/ask spread

measuring the inventory-holding premium

Nicolas P.B. Bollen, Tom Smith, Robert E. Whaley*

*Corresponding author for this work

Research output: Contribution to journalArticle

57 Citations (Scopus)

Abstract

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.

Original languageEnglish
Pages (from-to)97-141
Number of pages45
JournalJournal of Financial Economics
Volume72
Issue number1
DOIs
Publication statusPublished - Apr 2004
Externally publishedYes

Keywords

  • bid/ask spread
  • expected insurance cost
  • inventory-holding premium
  • semi-variance
  • stochastic time to expiration

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