Modeling the Bid/ask Spread: Measuring the Inventory-holding Premium

57 Pages Posted: 5 Dec 2002  

Nicolas P. B. Bollen

Vanderbilt University - Finance

Robert E. Whaley

Vanderbilt University - Finance

Tom Smith

University of Queensland; Financial Research Network (FIRN)

Date Written: October 1, 2002

Abstract

The need to understand and measure the determinants of market maker bid/ask spreads is crucial in evaluating the merits of competing market structures and the fairness of market maker rents. After providing a brief review of past work, this study develops a simple, parsimonious model for the market maker's spread that accounts for the effects of price discreteness induced by minimum tick size, order-processing costs, inventory-holding costs, adverse selection, and competition. The inventory-holding and adverse selection cost components of spread are modeled as an option with a stochastic time to expiration. This inventory-holding premium embedded in the spread represents compensation for the price risk borne by the market maker while the security is held in inventory. The premium is partitioned in such a way that the inventory holding and adverse selection cost components and the probability of an informed trade are identified. The model is tested empirically on a sample of NASDAQ stocks over three distinct tick size regimes and is shown to perform well.

Keywords: market microstructure, determinants of spread, option value

JEL Classification: G13, G24

Suggested Citation

Bollen, Nicolas P. B. and Whaley, Robert E. and Smith, Tom, Modeling the Bid/ask Spread: Measuring the Inventory-holding Premium (October 1, 2002). Available at SSRN: https://ssrn.com/abstract=336242 or http://dx.doi.org/10.2139/ssrn.336242

Nicolas P.B. Bollen

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States

HOME PAGE: http://mba.vanderbilt.edu/faculty/nbollen.cfm

Robert E. Whaley (Contact Author)

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States
615-343-7747 (Phone)
615-376-8879 (Fax)

Tom M. Smith

University of Queensland ( email )

4072 Brisbane, Queensland
Australia

Financial Research Network (FIRN) ( email )

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

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