Bias in the Effective Bid-Ask Spread
65 Pages Posted: 23 Mar 2017 Last revised: 11 Nov 2020
Date Written: November 11, 2020
The effective bid-ask spread measured relative to the spread midpoint overstates the true effective bid-ask spread in markets with discrete prices and elastic liquidity demand. The average bias is 13-18% for S&P 500 stocks in general, depending on the estimator used as benchmark, and up to 97% for low-priced stocks. Cross-sectional bias variation across stocks, trading venues, and investor groups can influence research inference. The use of the midpoint also undermines liquidity timing and trading performance evaluations, and can lead non-sophisticated investors to overpay for liquidity. To overcome these problems, the paper proposes new estimators of the effective bid-ask spread.
Keywords: midpoint, micro-price, liquidity demand elasticity, illiquidity, Rule 605, Tick History
JEL Classification: C15, G12, G20
Suggested Citation: Suggested Citation