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ABSTRACT

This paper employs a “transaction” data-base to study whether observed quote-revisions are consistent with those predicted by the adverse selection and inventory cost theories of the bid-ask spread. We find that actual quote-revisions are consistent with the theoretical prediction in only 25% of the cases. Furthermore, quote-revision patterns are found to be strongly dependent on the level of the outstanding spread and, to a lesser extent, on the transaction size. These systematic patterns, unrelated to the inventory cost and adverse selection theories, are consistent with the effect on quote-revisions of the limit order book and the minimum 1/8 price-change rule.