The Components of the Bid-Ask Spread: Evidence from the Corn Futures Market

This paper examines whether USDA announcements and commodity index fund rolling activity has an impact of liquidity costs, measured by the Bid-Ask-Spread. Using Huang and Stoll’s (1997) model of liquidity costs, we estimate whether changes to liquidity costs are driven by the adverse selection component, the inventory cost component, or the order processing component. Commodity index fund roll activity reduces the asymmetric information cost component of liquidity cost due to an increased proportion of non-information based trading, but the inventory cost component increases as (mostly long only) commodity index funds sell their nearby position and buy the first deferred contract – raising liquidity providers’ risk of building a position. The sum of these two effects is that liquidity costs remain low during index fund roll periods, averaging very near to one ‘tick’ (0.25 cents). On USDA report release days, we find that informed traders raise the asymmetric information component of liquidity costs in the first hour after release, but the inventory cost component is reduced due to the increase in volume associated with trading the report release. As was the case for commodity index fund roll activity, liquidity costs on USDA report release days remain low, averaging very near to one ‘tick’ (0.25 cents). Our finding that liquidity costs are very minimally changed during USDA report releases and commodity index fund roll periods is similar to other recent research on liquidity costs, but we show that what drives liquidity costs is very different depending on the circumstances surrounding trading on any given day.