Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests



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    • Owen Graduate School of Management, Vanderbilt University. This research was supported by grants from the Financial Markets Research Center and the Dean's Fund for Faculty Research at the Owen Graduate School of Management and from the NASD. I am also grateful to the NASD for providing the data for this study. The helpful comments of Kalman Cohen, Larry Harris, Paul Laux, and Robert Whaley are gratefully acknowledged.


The relation between the square of the quoted bid-ask spread and two serial covariances—the serial covariance of transaction returns and the serial covariance of quoted returns—is modeled as a function of the probability of a price reversal, π, and the magnitude of a price change, ∂, where ∂ is stated as a fraction of the quoted spread. Different models of the spread are contrasted in terms of the parameters, π and ∂. Using data on the transaction prices and price quotations for NASDAQ/NMS stocks, π and ∂ are estimated and the relative importance of the components of the quoted spread—adverse information costs, order processing costs, and inventory holding costs—is determined.