A Model of True Spreads on Limit Order Markets

Abstract:     
True spreads are not directly observable and represent the continuous demand and supply schedule for stock liquidity by heterogeneously informed market participants on limit order markets. Observed spreads are true spreads quantized by minimum market tick size. A maximum likelihood regression model of true spreads is developed. True spreads are modelled as a continuous positive distribution parameterized by stock turnover and volatility. Nominal stock price is not a significant explanatory variable in modelling true spreads. Nominal stock price is shown to be a significant explanatory variable of observed spreads only as an artifact of minimum tick size.

Number of Pages in PDF File: 28

Keywords: True Spread, Censored Spread, Observed Spread, Tick Size, Exchange Policy

JEL Classification: G14, C52

working papers series