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Some Analytical Results for Models of the Bid-Ask Spread

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  • Sunil K. Parameswaran
  • Sankarshan Basu

Abstract

The focus of this paper is on order processing models of the bid-ask spread, also termed as fixed-cost models. While other theories have been advanced to explain spreads, such as inventory holding costs and adverse selection, research indicates that the fixed cost component constitutes the bulk of the observed spread. This paper starts with the Roll model and the subsequent extension of Choi, Salandro and Shastri. It takes cognizance of the implications of such models for the observed stock prices and the mid-points of bid-ask quotes, to set up tests using the Generalized Method of Moments (GMM) technique. The paper develops an analytical variance-covariance matrix for the fixed cost model with instantaneous adjustment of prices to new information.

Suggested Citation

  • Sunil K. Parameswaran & Sankarshan Basu, 2020. "Some Analytical Results for Models of the Bid-Ask Spread," Business and Management Research, Business and Management Research, Sciedu Press, vol. 9(3), pages 34-45, September.
    • Handle: RePEc:jfr:bmr111:v:9:y:2020:i:3:p:34-45
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    References listed on IDEAS

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    1. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-1054, July.
    2. Amihud, Yakov & Mendelson, Haim, 1987. "Trading Mechanisms and Stock Returns: An Empirical Investigation," Journal of Finance, American Finance Association, vol. 42(3), pages 533-553, July.
    3. Andrew W. Lo, A. Craig MacKinlay, 1988. "Stock Market Prices do not Follow Random Walks: Evidence from a Simple Specification Test," The Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 41-66.
    4. Roll, Richard, 1984. "A Simple Implicit Measure of the Effective Bid-Ask Spread in an Efficient Market," Journal of Finance, American Finance Association, vol. 39(4), pages 1127-1139, September.
    5. Choi, J. Y. & Salandro, Dan & Shastri, Kuldeep, 1988. "On the Estimation of Bid-Ask Spreads: Theory and Evidence," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(2), pages 219-230, June.
    6. Hasbrouck, Joel & Ho, Thomas S Y, 1987. "Order Arrival, Quote Behavior, and the Return-Generating Process," Journal of Finance, American Finance Association, vol. 42(4), pages 1035-1048, September.
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    JEL classification:

    • R00 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General - - - General
    • Z0 - Other Special Topics - - General

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