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Keywords:

  • market microstructure;
  • bid-ask spread;
  • return volatility;
  • NYSE;
  • specialist;
  • inventory cost
  • G14

Abstract

This paper examines the relation between the bid-ask spread and the risk of the underlying stock. It provides evidence that the specialist is not only sensitive to the absolute level of volatility, but also to changes in the level of volatility. This sensitivity arises because of increased inventory risk for the specialist when volatility is changing. For the sample of very liquid stocks in this paper, the quoted spread and the inventory cost component of the spread are shown to increase significantly during trading periods when volatility is both increasing and decreasing.