Anatomy of Bid-Ask Spread Empirical Evidence from an Order-driven Market

Ming-Chang Wang, Lon-Ping Zu and Chau-Jung Kuo
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Ming-Chang Wang: Department of Finance and Banking, Cheng Shiu University
Lon-Ping Zu: Department of Finance and Banking, Shih Chien University
Chau-Jung Kuo: Department of Finance, National Sun Yat-Sen University

No 25, Money Macro and Finance (MMF) Research Group Conference 2006 from Money Macro and Finance Research Group

Abstract: Under fairly basic rationales, this paper provides a more general microstructure model of price quotation in an order driven market. Specifically, as an extension of Handa and Schwartz (1996), we decompose the equilibrium of the bid-ask spread, which is derived as a function of the weighted average of three factors including the different valuation of traders and the expected loss of adverse selection respectively from buyers and sellers, into the implicate components which evolve from the characteristics of traders and market competition. More importantly, we can distinguish the expected loss of adverse selection, which is endogenously formed in our model, between from buyers and from sellers and investigate the key determinants of the expected loss of adverse selection. The numerical tests clearly show the relationships between the spread and all exogenous parameters. Furthermore, the empirical tests using transaction data on all listed shares in TAIEX provide strong support for our model and show that the asset volatility and the probability of informed trading are significantly positively related to the adverse selection costs. Our results indicate that on average the different valuations account for approximately 26.02% of the bid-ask spread, seller’s expected loss of adverse selection account for 36.95% , and buyer’s one account for 37.03%.

Keywords: Market Microstructure; Order Strategy; Bid-Ask Spread; Adverse Selection Cost; Price Formation; Order Driven Market (search for similar items in EconPapers)
Date: 2007-02-02
New Economics Papers: this item is included in nep-fmk and nep-mst
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