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

  • 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

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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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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