Seasonal Variation in Bid-Ask Spreads

Abstract:     
Seasonal variation in bid-ask spreads, as well as variation conditional on inventory cost changes, adverse selection events, and competition among market makers, have been extensively documented in past studies. We contribute to the spreads literature by examining the extent to which spreads are influenced by a seasonal factor that has been shown to pervasively influence aspects of capital markets as varied as stock returns, bond returns, and mutual fund flows. Previous studies show these different facets of financial markets exhibit seasonal patterns related to seasonal depression (known as SAD, or seasonal affective disorder). The mechanism by which this medical condition influences financial markets is through the extensively documented connection between seasonality in the number of hours of daylight and depression, and through the experimentally validated link between depression and risk aversion. We explore the impact of seasonal depression on the inside spread of NASDAQ firms in the context of multiple heterogeneous market makers. We also consider more restrictive cases, including multiple homogeneous market makers, and a single market maker. We find theoretical and empirical results consistent with SAD having a narrowing influence on the inside spread during the fall and winter. The full extent of this narrowing amounts to 350 basis points for an equal-weighted index of NASDAQ firms and 20 basis points for a value-weighted index, which is substantial given average spreads are about 570 and 170 basis points respectively in the equal- and value-weighted indices. Consistent with prior research, we find that spreads are at their widest at year-end. However, without the narrowing influence of SAD, year-end spreads would be much wider still. Researchers wishing to model inside spreads, say to ascertain empirically the impact of adverse selection relative to inventory costs, monopoly power, or other considerations, need to be mindful of this strong seasonal, as does any market participant who has discretion in the timing of her trades.

Keywords: Stock returns, time-varying risk aversion, seasonal affective disorder, depression, behavioral finance

JEL Classifications: G12, G14

Working Paper Series