True Spreads and Equilibrium Prices

Abstract

Stocks and other financial assets are traded at prices that lie on a fixed grid determined by the minimum tick size permitted in the market. Consequently, observed prices and quoted spreads do not correspond to the equilibrium prices and true spreads that would exist in a market with no minimum tick size. This paper models the equilibrium movements of two latent variables: equilibrium price and spread by a bivariate autoregressive process with correlated errors. We estimate the parameters governing their movements using transaction prices and information on quoted bid-ask spreads. Due to the econometric complexities created by the rounding to a discrete grid we use Monte Carlo Markov Chain methods to implement the parameter estimation. The empirical analysis is performed on a selection of large, heavily-traded U.S. stocks. The results indicate that most of the quoted spread is attributable to the rounding of prices and the adverse selection component is small.

JEL Classification: C1, C11, C15, G1, G19