Modeling the bid/ask spread: On the effects of hedging costs and competition

The need to understand and measure market maker bid/ask spreads is crucial in evaluating the merits of competing market structures and security designs. Prior studies of bid/ask spreads suffer from several forms of misspecification, including inadvertent and erroneous use of weighted least squares regression. This study develops a simple, parsimonious model of the determinants of spread, and then tests it empirically on a sample of NASDAQ stocks. The model performs well and avoids the distortions of prior work. The study demonstrates the importance of proper model specification in providing meaningful inference regarding the determinants of spread.UnpublishedNon Peer ReviewedAnshuman, V. Ravi and Kalay, Avner, 1998, Market making with discrete prices, Review of Financial Economics 11 (1), 81-109. Bagehot, W., 1971, The only game in town, Financial Analysts Journal, 12-22. Benston, George and Hagerman, Robert, 1974, Determinants of bid-ask spreads in the over-the-counter market, Journal of Financial Economics 1, 353-364. Branch, Ben and Freed, Walter, 1977, Bid-ask spreads on AMEX and the big board, Journal of Finance 32, 159-163. Christie, William, Harris, Jeffrey, and Schultz, Paul, 1994, Why did NASDAQ market makers stop avoiding odd-eighth quotes?, Journal of Finance 49, 1841-1860. Copeland, Thomas E. and Galai, Dan, 1983, Information effects on the bid-ask spread, Journal of Finance 38, 1457-1469. Demsetz, Harold, 1968, The cost of transacting, Quarterly Journal of Economics 82 (February), 33-53. George, Thomas J. and Longstaff, Francis A., 1993, Bid/ask spreads and trading activity in the S&P 100 index options market, Journal of Financial and Quantitative Analysis 28 (September ), 381-397. Glosten, Lawrence R. and Harris, Lawrence, 1988, Estimating the components of the bidask spread, Journal of Financial Economics 21, 123-142. Harris, Lawrence, 1994, Minimum price variations, discrete bid-ask spreads, and quotation sizes, Review of Financial Studies 7, 149-178. Huang, Roger D. and Stoll, Hans R., 1994, Market microstructure and stock return predictions, Review of Financial Studies 7, 179-213. Kronmal, Richard A., 1993, Spurious correlation and the fallacy of the ratio standard revisited, Journal of the Royal Statistical Society, Series A 156, 379-392. Lightfoot, Lois, Martin, Peter, Atkinson, William, and Davis, Jeffrey, 1986. The effects of multiple trading on the market for OTC options. SEC, Directionate of Economic and Policy Analysis. Neal, Robert, 1987, Potential competition and actual competition in equity options, Journal of Finance 60, 511-531. Smith, Tom and Whaley, Robert E., 1994, Assessing the costs of regulation: The case of dual trading, Journal of Law and Economics 37 (April), 215-246. Stoll, Hans R., 1978b, The pricing of security dealer services: An empirical study of NASDAQ stocks, Journal of Finance 33, 1153-1172. Stoll, Hans R., 1978a, The supply of dealer services in security markets, Journal of Finance 33, 1133-1151. Tinic, Seha, 1972, The economics of liquidity services, Quarterly Journal of Economics 86, 79-83. Tinic, Seha and West, Richard, 1972, Competition and the pricing of dealer services in the over-the-counter market, Journal of Financial and Quantitative Analysis 8, 1707- 1727. Tinic, Seha and West, Richard, 1974, Marketability of common stocks in Canada and the U.S.A.: A comparison of agent versus dealer dominated markets, Journal of Finance 29, 729-746