Estimation of the Bid-Ask Spread and its Components: A New Approach

Posted: 9 Mar 2008

See all articles by Gautam Kaul

Gautam Kaul

University of Michigan, Stephen M. Ross School of Business

Thomas J. George

University of Houston - Department of Finance

Mahendrarajah Nimalendran

University of Florida - Department of Finance, Insurance and Real Estate

Abstract

We show that time variation in expected returns and/or partial price adjustments lead to a downward bias in previous estimators of both the spread and its components. We introduce a new approach that provides unbiased and efficient estimators of the components of the spread. We find that between 77 and 97 percent of the downward bias in previous spread estimate is caused by time variation in expected returns. More importantly, the adverse-selection component, though significant, accounts for a much smaller proportion (8 to 13 percent) of the quoted spread, at least for small trades, than the proportion (over 40 percent) previously reported in the literature. Order processing costs are the predominant component of quoted spreads.

Keywords: bid-ask spread, components, microstructure, adverse-selection

Suggested Citation

Kaul, Gautam and George, Thomas J. and Nimalendran, Mahendrarajah, Estimation of the Bid-Ask Spread and its Components: A New Approach. Review of Financial Studies, Vol. 4, pp. 623-656, 1991, Available at SSRN: https://ssrn.com/abstract=1104485

Gautam Kaul (Contact Author)

University of Michigan, Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109-1234
United States
734-764-9594 (Phone)
734-647-6861 (Fax)

Thomas J. George

University of Houston - Department of Finance ( email )

Houston, TX 77204
United States

Mahendrarajah Nimalendran

University of Florida - Department of Finance, Insurance and Real Estate ( email )

P.O. Box 117168
Gainesville, FL 32611
United States
352-392-9526 (Phone)
352-392-0301 (Fax)

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