Components of the Bid–Ask Spread and Variance: A Unified Approach

Abstract

We develop a structural model for the price formation and liquidity supply of an asset. Our model facilitates decompositions of both the bid–ask spread and the return variance into components related to adverse selection, inventory, and order processing costs. Furthermore, the model shows how the fragmentation of trading volume across trading venues influences inventory pressure and price discovery. We use the model to analyze intraday price formation for gold futures traded at the Shanghai Futures Exchange. We find that order processing costs explain about 50% of the futures bid–ask spread, whereas the remaining 50% is equally due to asymmetric information and to inventory costs. About a third of the variance in futures returns is attributable to microstructure noise. Trading at the spot market has a significant influence on futures price discovery, but only a limited impact on the futures bid–ask spread. © 2016 Wiley Periodicals, Inc. Jrl Fut Mark 36:545–563, 2016

Trades or quotes: Which drives price discovery? Evidence from Chinese index futures markets

“…The liquidity supply cost shows a slow upward trend at different times of the day. Hagstromer et al (2016) further divided liquidity supply costs into inventory pressure costs and order processing costs, and the weak upward trend here may be due to the increasing inventory pressure cost as trading proceeds, which will not be explored further in this paper because of the small inventory pressure cost.…”

Assessment of Asymmetric Information Cost in Indian Stock Market: A Sectoral Approach

“…Over the years, multiple models are proposed to estimate asymmetric information cost of bid-ask spread. Most popular among them are models proposed by Stoll (1989), George et al (1991) based on work by Roll (1984) and Stoll (1989), Glosten and Milgrom (1985), Glosten and Harris (1988), Hagströmer et al (2016), De Jong et al (1996) and Madhavan et al (1997). Later, many researchers such as Kim and Ogden (1996), Huang (2000), Menyah and Paudyal (2000) and Singh and Pandey (2013) followed empirical models to establish their works.…”

Comprehensive Market Microstructure Model: Considering the Inventory Holding Costs

“…The recent models assume that investors are not sensitive to their inventory levels. However, as claimed by Ahn et al (2002) and Hagströmer et al (2016), even in the order-driven markets, limit order traders play the role of liquidity suppliers, and their trading generates explicitly positive bid-ask spreads. These liquidity suppliers can regard their inventory levels and holding costs as significant when deciding to submit orders.…”