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What Explains the Bid-Ask Spread Decline after Nasdaq Reforms?

30 Pages Posted: 26 Nov 2003  

Yan He

Indiana University Southeast - School of Business

Chunchi Wu

SUNY at Buffalo - School of Management

Abstract

This paper examines whether the decrease in bid-ask spreads on Nasdaq after the 1997 reforms is due to a decrease in market-making costs and/or an increase in market competition for order flows. Unlike previous studies, we jointly examine how competition and trading costs affect bid-ask spreads. In addition, we separate the effects of informed trading and liquidity costs on bid-ask spreads. Informed trading cost is directly estimated for each Nasdaq stock using a Bayesian theoretic model. Empirical results show that market-making costs and competition significantly affect bid-ask spreads. The post-reform decrease in bid-ask spreads is largely due to both an increase in competition and a decrease in informed trading and liquidity costs on Nasdaq.

Suggested Citation

He, Yan and Wu, Chunchi, What Explains the Bid-Ask Spread Decline after Nasdaq Reforms?. Financial Markets, Institutions & Instruments, Vol. 12, pp. 347-376, December 2003. Available at SSRN: https://ssrn.com/abstract=465583

Yan He (Contact Author)

Indiana University Southeast - School of Business ( email )

4201 Grant Line Road
New Albany, IN 47150
United States
812-941-2308 (Phone)
812-941-2672 (Fax)

Chunchi Wu

SUNY at Buffalo - School of Management ( email )

Jacobs Management Center
Buffalo, NY 14222
United States

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