Evaluating Spread Decomposition Models with a Basket Security

46 Pages Posted: 12 Dec 2007

See all articles by Patricia Chelley-Steeley

Patricia Chelley-Steeley

Aston University - Aston Business School

Keebong Park

Department of International Business; Keimyung University

Date Written: March 1, 2008

Abstract

In this paper we evaluate the most widely used spread decomposition models. We argue that Exchange-Traded Funds (ETFs) should have lower adverse selection costs than appropriate control securities. We make this assertion because ETFs have the characteristics of a basket security described by Subrahmanyam (1991). As such, an ETF will diversify away the private information held by informed traders. Diversification of this information causes ETFs to have lower adverse selection costs than individual securities providing a criterion for evaluating spread decomposition models. Comparisons of adverse selection costs for ETF's and control securities obtained from spread decomposition models show that only the Glosten-Harris (1988) and the Madhavan-Richardson-Roomans (1997) models provide estimates of the spread that are consistent with the diversification of private information in a basket security. Our results are robust even after controlling for the stock exchange.

Keywords: spread decomposition, market microstructure, Exchange traded-funds, adverse selection cost

JEL Classification: D8, G1

Suggested Citation

Chelley-Steeley, Patricia and Park, Keebong, Evaluating Spread Decomposition Models with a Basket Security (March 1, 2008). Paris December 2007 Finance International Meeting AFFI-EUROFIDAI Paper, Available at SSRN: https://ssrn.com/abstract=1070831 or http://dx.doi.org/10.2139/ssrn.1070831

Patricia Chelley-Steeley (Contact Author)

Aston University - Aston Business School ( email )

Aston Triangle
Birmingham, B47ET
United Kingdom

Keebong Park

Department of International Business ( email )

Kyunggi-do
Korea

Keimyung University ( email )

Dalseo-Gu, Daegu 704-701
Korea, Republic of (South Korea)

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