True Spreads and Equilibrium Prices

Authors

  • Clifford A. Ball,

  • Tarun Chordia

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    • Clifford A. Ball is from the Owen School of Management, Vanderbilt University and Tarun Chordia is from the Goizueta Business School, Emory University. We thank Hank Bessembinder, Charles Cao, Siddhartha Chib, Bill Christie, Rob Engle, Larry Harris, Joel Hasbrouck, Roger Huang, Bruce Lehmann, Craig Lewis, Marc Lipson, Ron Masulis, Venkatesh Panchpag-esan, Paul Schultz, George Sofianos, Matt Spiegel, Hans Stoll, George Tauchen, Dan Weaver, and seminar participants at Emory University, UCLA, Vanderbilt University, Washington University, the NBER market microstructure program meeting, and the WFA meetings for helpful comments and suggestions. We especially thank Siddhartha Chib and John Geweke for providing the Bayesian Analysis, Computation and Communication subroutines. We are grateful to René Stulz (editor) and an anonymous referee whose comments and suggestions have greatly improved the paper. All errors are our own.


ABSTRACT

Stocks and other financial assets are traded at prices that lie on a fixed grid determined by the minimum tick size. Observed prices and quoted spreads do not correspond to the equilibrium prices and true spreads that would exist in a market with no minimum tick size. Using Monte Carlo Markov Chain methods, this paper estimates the equilibrium prices and true spreads. For large stocks, most of the quoted spread is attributable to the rounding of prices and the adverse selection component is small. The true spread and the adverse selection component are greater for mid-sized stocks.

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