Spread Decomposition and Commonality in Liquidity

U of New South Wales School of Banking and Finance Working Paper No. 12-2002

40 Pages Posted: 21 Jan 2003

See all articles by Thomas Henker

Thomas Henker

Bond University

Martin Martens

Erasmus University Rotterdam (EUR); Robeco Asset Management

Date Written: January 3, 2003

Abstract

There is a surprising absence of common factor variables in market microstructure models. In this study we extend Huang and Stoll's (1997) spread cost decomposition model to incorporate a market wide buying and selling pressure cost component. We find strong evidence that specialists take this common factor cost component into consideration when they set bid and ask quotes. Evidence that specialist firms take the next logical step and specifically manage their firm wide stock inventories is ambiguous. The common factor is found to be largest for securities with the highest trade frequencies. This size effect diminishes and becomes insignificant under the new decimal trading regime. The relative importance of the common factor spread component decreases as the pricing grid becomes finer, but remains highly significant.

Keywords: spread component, spread decomposition, commonality, microstructure

JEL Classification: G12

Suggested Citation

Henker, Thomas and Martens, Martin P.E., Spread Decomposition and Commonality in Liquidity (January 3, 2003). U of New South Wales School of Banking and Finance Working Paper No. 12-2002. Available at SSRN: https://ssrn.com/abstract=360180 or http://dx.doi.org/10.2139/ssrn.360180

Thomas Henker (Contact Author)

Bond University ( email )

Gold Coast, QLD 4229
Australia
+61 7 5595-1561 (Phone)

Martin P.E. Martens

Erasmus University Rotterdam (EUR) ( email )

P.O. Box 1738
3000 DR Rotterdam
Netherlands
+31 10 408 1253 (Phone)
+31 10 408 9162 (Fax)

Robeco Asset Management ( email )

Rotterdam, 3011 AG
Netherlands

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