The Effect of Decimalization on the Components of the Bid-Ask Spread

34 Pages Posted: 16 Jun 2002  

Scott Gibson

College of William and Mary - Mason School of Business

Rajdeep Singh

University of Minnesota - Twin Cities - Carlson School of Management

Vijay Yerramilli

University of Houston, C. T. Bauer College of Business

Abstract

Previous empirical studies that decompose the bid-ask spread were done when securities traded in discrete price points equal to one-sixteenth or one-eighth of a dollar. These studies concluded that inventory and adverse-selection costs were economically insignificant compared to order-processing costs. Natural questions arise as to: (i) whether price discreteness allowed market makers to enjoy excess rents, thus reducing the significance of the inventory and adverse selection costs; (ii) whether discreteness decreased the traders' incentives to gather information; or (iii) whether methodologies previously employed mis-estimated the inventory and the adverse-selection costs. We show that the recent conversion to decimal pricing results in significantly tighter spreads. However, the dollar value of spreads attributed to adverse selection and inventory costs do not change significantly. Almost all of the reduction occurs in the order-processing component. As a result, inventory and adverse-selection costs now account for a significantly larger proportion of the traded spreads. A plausible explanation is that the minimum tick size constraint previously in place under fractional pricing allowed market makers to enjoy spreads that were larger than their actual costs.

Suggested Citation

Gibson, Scott and Singh, Rajdeep and Yerramilli, Vijay, The Effect of Decimalization on the Components of the Bid-Ask Spread. EFMA 2002 London Meetings. Available at SSRN: https://ssrn.com/abstract=314271 or http://dx.doi.org/10.2139/ssrn.314271

George Scott Gibson (Contact Author)

College of William and Mary - Mason School of Business ( email )

P.O. Box 8795
Williamsburg, VA 23187-8795
United States
757/221-1673 (Phone)

Rajdeep Singh

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-624-1061 (Phone)
612-626-1335 (Fax)

HOME PAGE: http://umn.edu/~rajsingh

Vijay Yerramilli

University of Houston, C. T. Bauer College of Business ( email )

Houston, TX 77204
United States
713-743-2516 (Phone)

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