Determinants of the components of bid‐ask spreads on stocks

Sung‐Hun Kim and Joseph P. Ogden

European Financial Management, 1996, vol. 2, issue 1, 127-145

Abstract: In this paper we show that George et al. (GKN, 1991) estimators of the adverse selection and order processing cost components of the bid‐ask spread are biased due to intertemporal variations in the bid‐ask spread. We use alternative estimators that correct this bias and that are applicable to individual securities, and estimate these cost components empirically using data on NYSE/AMEX stocks. As expected, our results indicate that on average adverse selection costs account for approximately 50% of the bid‐ask spread, sharply higher than the estimates of 8‐10% obtained by GKN for NASDAQ stocks and 21% that we obtain for NYSE/AMEX stocks using GKN's estimators. We then conduct cross‐sectional regressions designed primarily to determine whether adverse selection costs vary across specialists after controlling for firm size and other factors. Consistent with previously established hypotheses, we find that adverse‐selection costs vary across specialists, and that this variation is related to the number of securities that the specialist handles.

Date: 1996
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