How reliable are adverse selection models of the bid-ask spread?

Robert Neal and Simon M. Wheatley

No 95-02, Research Working Paper from Federal Reserve Bank of Kansas City

Abstract: Theoretical models of the adverse selection component of bid-asked spreads predict the component arises from asymmetric information about a firm's fundamental value. We test this prediction using two well known models [Glosten and Harris (1988) and George, Kaul, and Nimalendran (1991)] to estimate the adverse selection component for closed-end funds. Closed-end funds hold diversified portfolios and report their net asset values on a weekly basis. Thus, there should be little uncertainty about their fundamental values and their adverse selection components should be minimal. Estimates of the component from the two models, however, average 19 and 52 percent of the spread. These estimates, while smaller than corresponding estimates from common stocks, are large enough to raise doubts about the reliability of these models.

Keywords: Financial markets; Stock - Prices (search for similar items in EconPapers)
Date: 1995
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