Estimation of Bid-Ask Spread and Its Components in Indian Stock Market Using Trade Prices

Abstract

In the absence of order-book data and limited information on quoted bid-ask spreads in the Indian stock market, this paper attempts to analyze the bid-ask spread in Indian market by estimating bid-ask spreads and its components from trade prices. The sample consists of tick-by-tick data for the time period January 2002 through to October 2008 of 160 stocks traded on the National Stock Exchange of India. We estimate implied bid-ask spreads and its components (adverse selection costs; combined inventory and order processing costs) using theoretical models. We find that all the models used in the study produce consistent estimates of bid-ask spreads and its components. In the Indian Stock Market, we find that the adverse selection cost and the combined order-processing and inventory-holding cost each account for approximately 50 percent of the bid-ask spread. We also find that the estimated bid-ask spreads are approximately 80 percent of the quoted bid-ask spreads. In our sample period, we find that the relative bid-ask spreads have decreased over the years.

Keywords: Bid-ask spread, adverse selection costs, inventory holding costs, order processing costs, order driven market

JEL Classification: C22, C32, G12