Bias in the Effective Bid-Ask Spread

77 Pages Posted: 23 Mar 2017 Last revised: 17 Apr 2020

See all articles by Björn Hagströmer

Björn Hagströmer

Stockholm University - Stockholm Business School

Date Written: April 17, 2020

Abstract

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 13-20% 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, liquidity, illiquidity, Rule 605, NBBO, TRTH

JEL Classification: C15, G12, G20

Suggested Citation

Hagströmer, Björn, Bias in the Effective Bid-Ask Spread (April 17, 2020). Swedish House of Finance Research Paper No. 20-1, Available at SSRN: https://ssrn.com/abstract=2939579 or http://dx.doi.org/10.2139/ssrn.2939579

Björn Hagströmer (Contact Author)

Stockholm University - Stockholm Business School ( email )

Stockholm
Sweden

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