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Relation between Bid-Ask Spread, Impact and Volatility in Double Auction Markets

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  • Matthieu Wyart

    (CEA Saclay;)

  • Jean-Philippe Bouchaud

    (Science & Finance, Capital Fund Management
    CEA Saclay;)

  • Julien Kockelkoren

    (Capital Fund Management)

  • Marc Potters

    (Science & Finance, Capital Fund Management)

  • Michele Vettorazzo

Abstract

We argue that on electronic markets, limit and market orders should have equal effective costs on average. This symmetry implies a linear relation between the bid-ask spread and the average impact of market orders. Our empirical observations on different markets are consistent with this hypothesis. We then use this relation to justify a simple, and hitherto unnoticed, proportionality relation between the spread and the volatility_per trade_. We provide convincing empirical evidence for this relation. This suggests that the main determinant of the bid-ask spread is adverse selection, if one considers that the volatility per trade is a measure of the amount of `information' included in prices at each transaction. Symmetry between market and limit orders stems from the self-organization of liquidity in electronic markets. Our results appear to hold approximately on liquid specialist markets as well, although the spread is significantly larger.

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Bibliographic Info

Paper provided by Science & Finance, Capital Fund Management in its series Science & Finance (CFM) working paper archive with number 500067.

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Date of creation: Mar 2006
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Handle: RePEc:sfi:sfiwpa:500067

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References

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Citations

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Cited by:
  1. Damien Challet, 2007. "Feedback and efficiency in limit order markets," Papers 0709.3005, arXiv.org, revised Sep 2007.
  2. Jean-Philippe Bouchaud & J. Doyne Farmer & Fabrizio Lillo, 2008. "How markets slowly digest changes in supply and demand," Papers 0809.0822, arXiv.org.
  3. J. Doyne Farmer & John Geanakoplos, 2008. "The virtues and vices of equilibrium and the future of financial economics," Papers 0803.2996, arXiv.org.
  4. Takero Ibuki & Jun-ichi Inoue, 2011. "Response of double-auction markets to instantaneous Selling–Buying signals with stochastic Bid–Ask spread," Journal of Economic Interaction and Coordination, Springer, vol. 6(2), pages 93-120, November.
  5. Willis, Geoff, 2011. "Why money trickles up – wealth & income distributions," MPRA Paper 30851, University Library of Munich, Germany.
  6. Gilles Zumbach, 2007. "Time reversal invariance in finance," Papers 0708.4022, arXiv.org.
  7. Moutot, Philippe, 2011. "Systemic risk and financial development in a monetary model," Working Paper Series 1352, European Central Bank.
  8. G.-F. Gu & W. Chen & W.-X. Zhou, 2007. "Quantifying bid-ask spreads in the Chinese stock market using limit-order book data," The European Physical Journal B - Condensed Matter and Complex Systems, Springer, vol. 57(1), pages 81-87, 05.

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