Components of the Bid-Ask Spread and the Statistical Properties of Transaction Prices



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    • J. L. Kellogg Graduate School of Management, Northwestern University. I would like to thank, without imputing responsibility for errors or omissions, participants in the finance workshops at Columbia, University of Minnesota, and University of Chicago. I would particularly like to thank George Constantinides, Doug Diamond, Wayne Ferson, Ravi Jagannathan, Bob Korajczyk, Rob Stambaugh, and an anonymous referee. Research support from the Institute for Quantitative Research in Finance is gratefully acknowledged. Part of the research for this paper was completed while visiting the Curtis L. Carlson School of Management, University of Minnesota.


The bid-ask spread can be decomposed into two parts: one part due to asymmetric information and the other part due to other factors such as monopoly power. The part due to asymmetric information attenuates statistical biases in mean return, variance, and serial covariance. Thus, using spread data to adjust for biases in return moments requires knowing not only the spread but the composition of the spread. Furthermore, any spread-estimation procedure using transaction prices must estimate two spread components. On the other hand, the appropriateness of some previously suggested statistical corrections is independent of the spread composition.