Modeling the bid/ask spread: Measuring the inventory-holding premium

Bollen, Nicolas P. B., Smith, Tom and Whaley, Robert E. (2004) Modeling the bid/ask spread: Measuring the inventory-holding premium. Journal of Financial Economics, 72 1: 97-141. doi:10.1016/S0304-405X(03)00169-7

Author Bollen, Nicolas P. B.
Smith, Tom
Whaley, Robert E.
Title Modeling the bid/ask spread: Measuring the inventory-holding premium
Journal name Journal of Financial Economics   Check publisher's open access policy
ISSN 0304-405X
Publication date 2004-04
Year available 2003
Sub-type Article (original research)
DOI 10.1016/S0304-405X(03)00169-7
Volume 72
Issue 1
Start page 97
End page 141
Total pages 45
Place of publication Amsterdam, Netherlands
Publisher Elsevier
Language eng
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. 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, as well as the probability of an informed trade, are identified. The model is tested empirically using Nasdaq stocks in three distinct minimum tick size regimes and is shown to perform well both in an absolute sense and relative to competing specifications.
Keyword Bid/ask spread
Inventory-holding premium
Expected insurance cost
Q-Index Code C1
Q-Index Status Provisional Code
Institutional Status Non-UQ
Additional Notes Available online 14 August 2003

Document type: Journal Article
Sub-type: Article (original research)
Collection: UQ Business School Publications
Version Filter Type
Citation counts: TR Web of Science Citation Count  Cited 32 times in Thomson Reuters Web of Science Article | Citations
Scopus Citation Count Cited 37 times in Scopus Article | Citations
Google Scholar Search Google Scholar
Created: Thu, 24 May 2012, 09:23:29 EST by Karen Morgan on behalf of UQ Business School