Market Microstructure

Regulatory change:
Financial markets some times change their trading system, their rules and regulations
that related to many aspects within these markets. Such changes in rules and
regulations consider very important issue in market microstructure that attract a great
attention of academic, practitioners, and regulators to examine and find out the effect
and the consequences of these changes in regulations.

Changing in tick size is one of these changes in regulation, and determining the
optimal tick size still subject to great debate among academic, practitioners and
regulators. Tick size or the minimum price increment can be defined as the smallest
amount by which two prices can differ (Harries (2003)). On June 24, 1997 NYSE
lowered its minimum price increment from eights of dollar to sixteenths of dollar.
Jones and Lipson (2001) used a sample of institutional trade to measure the effect of
the reduction in tick size in NYSE on execution costs. They began the analysis by
calculating the standard measures of execution costs before and after the change to
evaluate the reduction in tick size based on 1,690 firms traded on the NYSE. And
since institutions tends to trade large quantities of stocks and establish or liquidity
positions over time, the traditional spread measures do not take in consideration all of
the costs related to institution’s trading strategies and information on trades and
quotes is inadequate for measuring execution costs, so they used a sample of
institutional equity orders provided by Plexus Group1 which contains 386,487 orders
executed for Plexus clients in 1,271 NYSE stocks, which are a subset of the 1,690
TAQ firms. Here

From their analysis which based on regression models, their paper provides an
evidence that institutions as a group pay more under sixteenths, that is, it seems
unlikely that benefits outweigh costs under sixteenths. While the cost of individuals
trades of all size declines under this change, the execution costs are higher for all but
the smallest institutional orders under sixteenths. They also found that many kinds of
orders and institutions are unaffected by the tick reduction, and the liquidity
demanders such as momentum traders and those submitting large orders bear most of
the increased cost. Moreover, they found that institutions break up trades more often
1
Plexus Group is a widely recognized consulting firm that works with institutional investors to monitor
and reduce their equity trading costs (Jones and Lipson (2001)).

1
post sixteenths. Finally, it seems that spreads as traditional liquidity measures are not
sufficient statistic for market quality; in particular, effective spreads are not a
sufficient statistic for institutional execution costs. In this paper they focus on
examining the execution costs for institutions and the source of the data they based on
in their analysis don’t provide any information about individual trades and all of the
data highlight the importance of studying orders rather than trades, and this may result
in making their results inapplicable to all investors.

Also, Chung and Chuwonganant (2002), examined the effect of the change in tick size
in NYSE on another issue, that is, compared with previous studies1 which examined
the impact of the change in tick size on dealer specialist quotes, and focused primary
on how tick size reduction affected quoted spreads and depth, this study examined
how the change in minimum price increment affect quote revisions on the NYSE, in
other words, they analyze who specialists and other liquidity suppliers use the spread
and depth in quote revisions, and whether the variation in tick size has altered their
quote revision behavior. They used the trade and quote data during 30 trading days
immediately before and after the date on which the minimum price variation changed
from $ 1/8 to $ 1/16. The length of the sample period consider short so this mean that
the result will reflect the short-term effect of the change. These data were obtain from
NYSE’s trade and quote database, so about 2,725 NYSE stocks were subject to
filtering process which end with a total of 2,223 stocks as a final study sample.

From the analysis it found that specialists are more likely to revise depth quotes for
stocks with large volume, low price or low risk, and conversely they are more likely
to revise spread quotes for less-traded, high priced, or riskier stocks. In other words,
specialists and other liquidity providers on the NYSE rely much less on price quotes
than size quotes for low price, high volume, and low-risk stocks, even after reducing
tick size to $ 1/16, and from the analysis of intraday variation of the quote revisions
they found that the number quote revisions that involve charges in the spread (depth)
is largest (smallest) during the early hours of trading in both periods before and after
the change in tick size. From these results it appears that tick size was still a
constraining factor in price discovery process on the NYSE.

Changing in tick size not only took place in NYSE, it also took place in Nasdaq stock
exchange, that is on June 2, 1997 the tick size on Nasdaq stock exchange changed
1
Write about previous studies from page 392 in Chung and Chuwonganant (2002) copy and past.

2
from $/8 to $1/16 for stocks with a price greater than $10. Chung and Ness (2001) in
their paper perform empirical analysis of the effect of the change in tick size on
intraday variation in bid-ask spreads and quoted depths of Nasdaq traded stocks,
which helps in proved an understanding of how market makers and limit-order traders
deal with the inventory and adverse selection problem. They based their analysis on
the data from NYSE’s Trade and Quote database, and the selection of the sample was
based on identifying Nasdaq stocks for which the new SEC rules were in effect, so the
initial sample comprises 150 stocks, of these stocks, they obtained data on 134 stocks
for period from October 1, 1996 to September 30, 1997, and divided this period into
three subperiod to take in consideration another change in rules that will be discussed
later, also they apply several errors filters to data to minimize the error. Trading day
has been partitioned into 13 successive 30-minute intervals and calculates the time-
weighted spread for each stock during each 30-minute interval.

By applying the dummy variable model and used generalized method of moments
(GMM) to estimate the models, they found that there is a significant decrease in
spreads (absolute and proportional spread) after the decline in tick size which is
consistent with Jones and Lipson (2001), when they found that both quoted and
effective spreads decline in NYSE after the reduction in tick size, and also consistent
with Goldstein and Kavajecz (2000). They also found that the magnitude of the
decline is largest during the final hour of trading, which is consistent with the
conjecture that there is an aggressive management of the inventory by Nasday dealers
near the close as the smallest tick size make it less costly to jump in front of inside
spread, also this result may indicted that liquidity providers are less motivated to jump
in front of the inside spared during the early hour of grading because the existence of
information asymmetry between informed traders and liquidity providers.

They also found that depth declined after the reduction in tick size and the magnitude
of the decrease I smallest during the early hour of trade, which consistent with
findings of Jones and Lipson and Goldstein and Kavajecz (2000) that there is a
smaller depth after tick size reduction for NYSE stocks.

This study showed the significant effect that the market microstructure has on trading
costs and for the investor welfare and market quality is necessary to have proper
regulatory oversight of securities markets and establishment of proper trade and quote
dissemination protocols.

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Another important change in financial market’s rules and regulation that was to
intensive search and study is the changing in pricing system, that is, moving from
fractional pricing system to decimal pricing system. New York Stock Exchange
replaced the system of frictional pricing to decimal pricing on January 29, 20011; this
stock exchange was the leader in the conversion to decimal pricing. Also Nasdaq
stock market moved to decimalization on April 9, 2001. This change in pricing
system was subject to many researches to examine its possible effect on financial
market’s characteristics. Bessembinder (2003) assessed the trade execution cost and
market quality for Nasdaq and NYSE stocks before and after the change to decimal
pricing to give perspective which market structure is optimal, also his study consider
important to portfolio managers since I provide knowledge about the execution cost
for transaction. He depend on sample include 172 million trades and 187 million
quotations on 600 stocks, where 300 common stock from Nasdaq and 300 from
NYSE which are matched on the basis of market capitalization, the sample period
cover three weeks before the change in pricing system in YSE and after
decimalization it extended to 21 weeks after Nasdaq market decimalized, moreover,
the sample include trades completed both on and off the listing market.

He found that after decimalization, spreads have been decreased, especially for
heavily traded large capitalization Nasdaq stocks and large capitalization NYSE listed
stocks. The results also show that quotation size decrease in both markets and price
improvement rate increase in NYSE but not in Nasdaq, these results verifying all of
the prediction of Harris (1999). His results about the reduction in spreads and
quoution size are consistent with the results of Chung and Ness (2001), Goldstein and
Kavajecz (2000) and Jones and Lipson (2001) that examine the effect of the changing
in tick size from $1/8 to $1/16 in Nasdaq for the first two and for NYSE for the last
one. Regarding the market quality, they found that intraday return volatility declined
after decimalization, narrower average, effective, quoted, and realized bid-ask spreads
on both markets, and the absence of systematic reversals of quote changes on either
markets. All of these indicate that market quality has been improved. These results
support the conclusion that smaller traders who used market orders are benefited and
there is a noticeable decrease in average execution costs for large trades, which is

1
Insert note abut the change in decimalization from Bessembinder (2003) and Gibson et al. (2003)

4
consistent with the reasoning that large traders also have benefited from
decimalization.

Finally, since the spreads on large capitalization Nasdaq stocks are narrower than on
that one in NYSE after decimalization, which support the conclusion what quoted
Nasdaq spreads are narrower after decimalization. But still that small and medium
capitalization stocks still have narrower average spreads on the NYSE, these results
based on quoted spreads and trading volume weighted averages but when based on
simple averages across stocks tend to support the conclusion that post-decimalization
quoted spread are narrower in NYSE. Moreover, sine the effective bid-ask spread as a
percentage of share price is arguably the most relevant measure of trade execution
cost, so this study show that effective spreads for large NYSE stock don’t exceed
quoted spread after decimalization, while the opposite is true for large Nasdaq stocks,
and for small and medium capitalization stocks, execution costs are higher on Nasdaq
than the NYSE after decimalization.

One important limitation of this study is that the results reported are base on publicly
available trade and quote data, and don’t provide any direct evidence on trading cost
for large institutional trading programs.

In addition, Gibson et al. (2003) examine the components of bid-ask under new
pricing system (decimalization), that is, they examine how the size of each of the
various components of bid-ask spread (inventory and adverse selection) that together
comprise the traded spread changed with the conversion to decimal pricing. This is
considers new issue that is tested under decimalization in addition to market quality,
trade execution costs and quote reversion.

This study conducted on S&P 500 stocks that are listed in NYSE and the final sample
after filtering contain 415 stock, the sample period which extended from December
11,2000 to March 23, 2001 has been divided into two periods from December 11,
2000 to January 26, 2001 and form February 5, 2001 to March 23, 20011. So they
have a test ample of 386 stocks and control sample of 29 stocks 2. To allow the market
to adjust after the commencement of decimalized trading they excluded the trading
week of January 29 to February 2. Trade and quotes data for these stocks are obtained

1
All stocks have been moved on January 29, 2001.
2
These stocks are traded under the decimal pricing system for the whole sample period.

5
from the TAQ dataset distributed by the NYSE, while the number of shares and daily
returns are obtained from CRSP dataset.

They employ the methodology proposed by Huang and Stoll (1997) to decompose the
traded spread into order-processing components and into inventory plus adverse-
selection components in order to see how the components of spread changed to affect
the tightening in spreads. Moreover, in order also to understand how these revenues
were affected, they examine realized spread and follow the methodology of
Bessembinder (2002) to calculate the realized spread. They analyzed the data using
descriptive statistic and run regression analysis of both proportional spread and dollar
spread.

They found that traded spreads were lower in the control sample relative to the test
sample prior to conversion, also traded spreads decline significantly in test sample at
the time of conversion. The lower spreads under decimalization prove to hold when
trades of different sizes are examined separately, with small trades exhibiting the
greatest declines. The decrease in spreads as found in this paper is consistent with the
results of Bessembinder (2003), and with other studies that examine the effect of
change in tick size like Jones and Lipson (2001), Goldstein and Kavajecz (2000), and
Chung and Ness (2001). Moreover, they found that both cost components inventory
and adverse selection costs show insignificant net changes after decimalization, but
almost all of the decline in traded spreads results form a reduction in the order-
processing components under the decimal regime. Their spread-decomposition
analysis is consistent with increased the competition between limit orders and market
makers, which reduce market maker profit. And they also showed that the
underestimated of the contributions of inventory and adverse-selection costs
components to the traded spread is not because of the flaws in followed
methodologies in previous studies but it is because of high order-processing cost
component.

Finally, they found from analyzing the cross-sectional relationship between

proportional traded spreads and stock characteristics, that there is a negative
relationship between proportional traded spreads in test sample prior to conversions
with stock’s daily dollar volume, number of daily trades and market capitalization, but
positive relationship with price volatility, and all the coefficients for test sample show
insignificant change after conversion.

6
Moreover, Chakravarty et al. (2005), take a close look to the mixed results regarding
market liquidity that obtained from studies that conducted at the beginning of
decimalization by comparing the adverse selection costs for a sample of NYSE
around complete decimalization and compare adverse selection costs with matched
sample of non-decimalized Nasdaq stocks. They also investigate the relation between
adverse selection costs and trade size as a result of decimalization.

They tested a sample of 304 NYSE stocks for the period of January and February
2001, and define the period of January 1, 2001 through January 26, 2001 as the before
period and the period of January 29, 2001 through February 28, 2001 is the after
period. They used tick by tick trade and quote data from NYSE over that period and
they used a Nasdaq Sample as a benchmark, where stocks still traded in sixteenth over
the sample period, matched with NYSE stocks based on market value of equity. It
seems that the sample period is too short so the results will only reflect the short-term
effect.

To accommodate transactions data they employed the estimation procedures of

George et al. (1991), and Lin et al. (1995) as modified by Neal and Wheatley (1998).
Also they follow Lee and Ready (1991) procedure to determine trade classification.

Compared with Gibson et al. (2003) which found that adverse selection and inventory
costs components show insignificant net change in NYSE after decimalization, They
found that there is an increase (decrease) in the percentage of adverse selection (dollar
adverse selection) costs following the decimalization in NYSE, which indicate that
the total costs of adverse selection has decreased with decimalization. But no
significant difference in either the dollar or percentage adverse selection costs for the
Nasdaq. And from estimating the adverse selection components by trade size classes
they found that it declines in trades of all size, with a strong evidence come from
trades with medium size, followed by small and the large trades. That is, even though
the two models used conflict in the results regarding adverse selection cost associated
with small trade in NYSE (GKN model) and that associated with large trade in NYSE
(LSB model) that both of them do not change significantly, but they agree on medium
size trades, finally, a after decimalization they found that, it appears that there is a less
stealth trading and less institutional trading. One possible reason for the lower adverse
selection costs following total decimalization is the lack of participation by informed

7
traders as indicted by the reduction in large size trading, and by the lack of stealth
trading as evidenced by an unchanged number of medium size trades.

Overall, all of these results consider complements to the findings of Chakravarty et al.
(2004) and Bacidore et al. (2003) and also provide a good understanding of the cost of
liquidity on NYSE after decimalization.

8
Order Handling Rules, Tick Size, and the Intraday Pattern of Bid-Ask Spreads
for Nasdaq Stocks
Kee H. Chung, Robert A. Van Ness
Journal of Financial Markets 4 (2001) 143-161.

9
Many of market microstructure studies examine the effects of market structure on
price discovery and trading costs. One issue of market microstructure is the changing
in regulations and trading rules. According to this study, Nasdaq experience changes
in order handling rules such as limit order display rule (new rule known as quote rule)
and also changing in quote-dissemination protocols (e.g. changing in tick size). So
this study examine how intraday variation in the spread and quote affected by
changing in rules. So it shed the light on the role of limit order traders in the price
discovery process, since new order handling rules allow them to participate in the
quote-setting process, also this study helps understand how market makers and limit
orders deal with inventory and adverse selection problem through the analysis of the
effect of tick size change on intraday spreads and depths.

They perform empirical analysis of the effect of the OHR changes and tick size
change on intraday variation in spreads by comparing the intraday pattern of spreads
immediately after and before the rule changes, and also they examine the effects of
these rules changes on quoted depths of Nasdaq stocks.

Basing the analysis on two hypotheses1, they collect data from NYSE’s Trade and
Quote database. They based sample selection on identifying Nasdaq stocks for which
the new SEC rules were in effect, the initial sample comprises 150 stocks, of these
stocks, they obtained data on 134 stocks from the TAQ database for period from
October 1, 1996 to September 30, 1997, and divided this period into three subperiod,
they apply several errors filters to data to minimize the error. Trading day has been
partitioned into 13 successive 30-minute intervals and calculates the time-weighted
spread for each stock during each 30-minute interval.

In order to analysis the effect of the OHR changes on intraday variation in spread and
depth they follow the dummy variable model and used generalized method of
moments (GMM) to estimate the models. The same model is also applied to examine
the effect of tick size change on intraday variations in spread.

1
These two hypotheses are: the first one; The magnitude of spread reductions
associated with changes in the order handling rules is larger during midday than
other times of the day. and the second one; The impact of the tick-size change on
spreads is smallest during the early hour of trading and largest during the last
hour of trading.

10
They found that after the introduction of the new order handling rules that bid-ask
spread decline significantly and the extend of the decline is large during the midday,
which suggest that order handling rule changes have significant impact on intraday
variation in spread for Nasdaq stocks, and also suggest that the new order handling
rules allow limit-order traders to play a significant role in the quote-setting process.

In addition, the average depth increased through out the trading day after the order
handling rules change and the magnitude of the increase is largest (smallest) during
the last (early) hours of trading, which indicate that market makers and limit order
trades start to show their trading interests.

Moreover, they found that when the tick size decline from one eight to one sixteen
there is a significant decrease in spreads and the magnitude of the decline is largest
during the final hours of trading, and this can be explained by the aggressive
management of Nasdaq Dealers to their inventory near the close as the small tick size
make it less costly for them to jump in front of the inside spread.

There is an idea in conclusion look at it.

Trade Execution Costs and Market Quality after Decimalization

Hendrik Bessembinder
Journal of Financial and Quantitative Analysis
Vol. 38 No. 4 December 2003

Many of structural charges take place in financial markets, that is, the New York
Stock Exchange changed the fractional pricing system to decimal pricing on January
29, 2001, also in the same year Nasdaq Stock Market decimalized on April 9, 2001.
Both markets were subject to other change before they move to decimalization, the
minimum price increment “tick size” has been reduced to one cent on both markets.

Like other studies that test the effect of changing in market structure, this study
assessed the trade execution costs and market quality for Nasdaq and NYSE stocks
before and after the change to decimal pricing. Such study consider very important
because it gives perspective which market structure is optimal, and provide a
knowledge to portfolio managers about the execution cost for transaction, moreover,
compared with other studies that test the effect of smaller tick size it provide direct
evidence on and tests of hypotheses regarding decimalization.

11
In this study, three measures of trading costs are considered which are effective
spreads, quoted bid-ask spreads and realized bid-ask spreads, and it is also consider
the following measures of market quality: quote sizes, intraday return volatility, the
competitiveness of quotes origination off the listing market, and the tendency for
quote changes to be systematically reversed within the trading day.

Since the overall conclusion is sensitive to the method by which results are averaged
across sample stocks, two procedures are followed; in the first, the number of shares
transacted weights each trade and the overall mean for the market is computed as the
share volume-weighted average of the stock means, in the second one, each trade in a
stock is weighted equally to compute the mean for the stock and the mean for the
market is obtained as the simple average across stocks. This study used a standard t-
test for equality of means to assess the statistical significance and results are obtained
in three stages: each mean is computed on a stock week basis, then results are
aggregated across weeks to obtain a mean for each stock, finally results are
aggregated across stocks to obtain a final mean for the market, in this stage, based on
cross-sectional variation in the stock specific means, statistical significance has been
assessed.

The sample of this study include 172 million trades and 187 million quotations on 600
stocks, where 300 common stocks from Nasdaq and 300 from NYSE which are
matched on the basis of market capitalization, before decimalization the sample cover
three weeks before the change in pricing system in NYSE, and the sample after
decimalization extended to 21 weeks after NASDAQ market decimalized, also the
sample include trades completed both on and off the listing market.

He found that after decimalization spreads have been decreased, specially for heavily
traded large capitalization Nasdaq stocks, also in large capitalization NYSE listed
stocks. The results also show that quotation size decrease in both markets and price
improvement rate increase in NYSE but not in Nasdaq, these results verifying all of
the prediction of Harris (1999). Regarding the market quality, they found that intraday
return volatility declined after decimalization, narrower average, effective, quoted,
and realized bid-ask spreads on both markets, and the absence of systematic reversals
of quote changes on either markets.

12
Finally, as indicated by variance ration analysis, there is no damaging lack of liquidity
in the wake of decimalization, all of these finding indicate that market quality has
indeed been improved.

Criticize: the results reported here are based on publicly available trade and quote data
and do not provide direct evidence on trading costs for large institution trading
programs.

Further research: a complete assessment of the impact of decimalization on market

quality will also require access to proprietary data on institutional trading programs, in
order to assess whether trading costs for large institutions have also declined.

Sixteenths: Direct Evidence on Institutional Execution Costs

Charles M. Jones, Marc L. Lipson
Journal of Financial Economics
59 (2001) 253-278

An important change has take place in NYSE’s trading rules, that is, on June 24,
1997, NYSE lowered its minimum price increment on most of stocks to be sixteenths
of dollar instead of eights of dollar, which consider from NYSE perspective an
interim step in a move toward price increments and decimalization of prices. Even
though optimal minimum price increment or tick size still subject to great debate
among academics, practitioners and regulators. This study conducted to directly
measure the effect of reduction in tick size on execution costs for institutional traders.

They began by calculating standard measures of liquidity and execution costs before
and after the sixteenths to evaluate the tick size reduction. They base the analysis on a
sample of 1,690 firms traded on NYSE using Trades and Quotes data. And since the
information on trades and quotes is inadequate for measuring execution costs, they
used a sample of institutional equity orders provided by the Plexus Group, which
include all Plexus client equity trades in NYSE listed stocks within 100 trading days

13
of the NYSE change to sixteenth. So the sample contains 386,487 orders executed for
Plexus clients in 1,271 NYSE stocks, which are a subset of the 1,690 TAQ firms.

The summary statistics shows that both quoted and effective spreads decline under
sixteenths and the effect of change is more pronounced for the firms with the smallest
spreads prior to the change, in addition, the statistical tests for a structural break
indicate that there is a change in daily mean spread, they also found that quoted depth
declined which consistent with prior research. Moreover, basing on Plexus trading
costs data before and after change to sixteenths it has been found that their is
substantial increase in execution costs, and this increase in costs is associated with
smaller quoted dollar spreads. But this change result in a reduction in liquidity as
suggested by the results for large orders and this proved by examining the execution
costs for different trading style, that is, it has been found that execution cost for
momentum traders are much grater than that for either value mangers or indexers. In
other words evidence indicates that the reduction in tick size leads to reduce
willingness to provide immediacy.

All of these results mentioned above depend on descriptive analysis, so in addition to

that, this study used simple approach (regression equation) to control for order,
mangers and market characteristics:

C j = α0 + α1 D j + X j β + ξ j 1

They identify a benchmark pre-sixteenths regressions in order to identify changes in

the determinants of execution costs. Standard t-tests for cross-sectional means and
Wilcoxon signed rank tests for cross-sectional medians to conduct inferences and they
found that all variables are significant and of the expected sign with the exception of
MOMEN (the return over the two trading days prior to the day an order is released,
multiplied by -1 if an order is a sell) and RANG (which is the difference between the
highest and lowest mid-quote prices on the day before an order is released to the
trading desk dividend by the mid-quote price at the close of trading that day) neither
of with is significant in the benchmark regression. By comparing the coefficients in
the pre- and post- sixteenths time period the results suggest that there is an increase in
cost of placing larger orders, and there is an increase in the costs incurred by
momentum traders and value traders relative to index traders.

1
Back to the paper to see the definition of equation terms.

14
They finish their analysis by comparing worked orders to other orders, and found that
both worked and non-worked orders2 are more costly to execute under sixteenths but
the effect is bigger for non-worked orders so one could expect traders to work more
orders.

In summary, the evidence in this paper show that institutions as a group pay more
under sixteenths, that is, it seems unlikely that benefits outweigh costs under
sixteenths. While the cost of individuals trades of all size declines under this change,
the execution costs are higher for all but the smallest institutional orders under
sixteenths. Many kinds of orders and institutions are unaffected by the tick reduction.
Moreover, liquidity demanders such as momentum traders and those submitting large
orders bear most of the increased cost. Finally, it seems that spreads as traditional
liquidity measures are not sufficient statistic for market quality; in particular, effective
spreads are not a sufficient statistic for institutional execution costs.

Criticize: it investigate the execution cost only for institutions, and depend only on
data for the institutional investors provided by Plexus Group which also don’t provide
information on the individual trades, so the results may not be applicable to all
institutional investors. Also, all of the data highlight the importance of studying orders
rather than trades.

Further research: look to paper

Tick Size and Quote Revisions on the NYSE

Kee H. Chung, Chairat Chuwonganant
Journal of Financial Markets
5 (2002) 391-410

This study also examine the effect of change in tick size and moving toward
decimalization in NYSE, that is, New York Stock Exchange whiteness a change in its
pricing rule by reducing the minimum tick from $1/8 to $1/16 on June 24, 1997, and
also move to decimalization on August 2000.
2
Orders are classified as worked orders if the orders are executed over more than one day or executed
by more than one broker.

15
Compared with previous studies that examine the impact of tick-size change on dealer
/ specialists quotes which show that the tick size change has significant effects on the
spread and depth of NYSE listed stocks, this study examine how the minimum price
variation affects quote revision on NYSE, that is they analyze how specialists and
other liquidity suppliers use the spread and depth in quote revisions and whether tick
size change has altered their quote revision behavior.

They depend on data obtained from NYSE’s TAQ database, that is they used the trade
and quote data during 30 trading days immediately before and after the date on which
the minimum price variation changed from $ 1/8 to $ 1/16, a total of 2,725 NYSE
stocks were subject to filtering process which end with a total of 2,223 stocks as a
final study sample.

So by using this sample they perform a before-and-after analysis of quote revision

behavior surrounding the tick size change, that is, they examine how price
discreteness affects quote revisions and whether pre-decimalization tick sizes were
binding constraints on absolute spreads, moreover, they also analyze intraday
variation in quote revisions and thereby shed further light on whether the minimum
price variation affects the relative use of spreads and depth over different times of the
day.

In addition, to examine the relation between quote revision behavior and stock
characteristics they run for regressions, that is, they regress change in spreads,
changes only in spread, change in depth and change only in depth in each regression
against four stock attributes share price, the number of trades, trade size and the
standard deviation of daily stock returns.

They found that specialists are more likely to revise depth quotes for stocks with large
volume, low price or low risk, and conversely they are more likely to revise spread
quotes for less-traded, high priced, or riskier stocks. In other words, specialists and
other liquidity providers on the NYSE rely much less on price quotes than size quotes
for low price, high volume, and low-risk stocks, even after reducing tick size to $
1/16, and from the analysis of intraday variation of the quote revisions they found that
the number quote revisions that involve charges in the spread (depth) is largest
(smallest) during the early hours of trading in both periods before and after the change

16
in tick size. From these results it appears that tick size was still a constraining factor in
price discovery process on the NYSE.

Finally, this study also found that decimalization is likely to reduce price rigidity and
increase price competition, and the relative frequency of spread- and price-quote
revisions inversed significantly after the implementation of decimal pricing on the
NYSE.

Criticize: the length of sample used in this study is too short so it can’t reflect the
long-term effect of the change.

Further research: while the results of this study show that specialists tend to change
their depth quotes more frequently than spread quotes, they have not established the
intertemporal link between these quote changes and concurrent shocks such as
changes in trade size, price volatility, and the number of trades.

Another area of research is the comparative analysis of quote revision behavior

between NYSE specialists and Nasdaq dealers.

The Effect of Decimalization on the Components of the Bid-Ask Spread

Scott Gibson, Rajdeep Singh, and Vijay Yerramilli
Journal of Financial Intermediation
12 (2003) 121 -148
Previous studies about market microstructure were conducting when securities traded
in discrete price points equal to one-sixteenth or one-eighth of a dollar. With well-
publicized conversion by NYSE on July 25, 2000 to decimal pricing from fractional
pricing. This stock exchange (NYSE) was the leader in the conversion to decimal
pricing. This change, the one-cent minimum tick size has reshaped the trading
environment for market makers and investors, as well as creation the possibility for
systematic changes in spreads. So, in this study they examine how the size of each of
the various components of bid-ask spread (inventory and averse selection) that
together comprise the traded spread changed with the conversion to decimal pricing,

17
which consider good contribution to other literature that examine different issues after
decimalization such as market quality and trade execution costs, and quote revsion.

This study has been conducted on S&P 500 stocks that are listed on the NYSE, and
these stocks filtered so after the exclusions the total number of stocks in their final
sample is 415.

Since the conversion began with seven stocks and then a large number of stocks have
been moved, they consider two time periods of seven trading weeks each; the first
one, from December 11, 2000 to January 26, 2001 and the second one form February
5, 2001 to March 23, 2001. So they have a test ample of 386 stocks and control
sample of 29 stocks. Trade and quotes data for these stocks are obtained from the
TAQ dataset distributed by the NYSE, while the number of shares and daily returns
are obtained from CRSP dataset.

In the empirical tests, they compare the spreads of the test and control samples in
periods 1 and 2, in addition, they employ the methodology proposed by Huang and
Stoll (1997) to decompose the traded spread into an order-processing components and
into inventory plus adverse-selection components in order to see how did the
components of spread change to affect the tightening in spreads. Moreover, in order
also to understand how these revenues were affected, they examine realized spread
and follow the methodology of Bessembinder (2002) to calculate the realized spread.
In analyzing data this study used descriptive statistic and run regression analysis of
both proportional spread and dollar spread.

They found that traded spreads were lower in the control sample relative to the test
sample prior to conversion, also traded spreads decline significantly in test sample at
the time of conversion. The lower spreads under decimalization prove to hold when
trades of different sizes are examined separately, with small trades exhibiting the
greatest declines. Moreover, they found that both cost components inventory and
adverse selection costs show insignificant net changes after decimalization, but almost
all of the decline in traded spreads results form a reduction in the order-processing
components under the decimal regime. Their spread-decomposition analysis is
consistent with increased the competition between limit orders and market makers,
which reduce market maker profit. And they also showed that the underestimated of
the contributions of inventory and adverse-selection costs components to the traded

18
spread is not because of the flaws in followed methodologies in previous studies but it
is because of high order-processing cost component.

Finally, they found from analyzing the cross-sectional relationship between

proportional traded spreads and stock characteristics, that there is a negative
relationship between proportional traded spreads in test sample prior to conversions
with stock’s daily dollar volume, number of daily trades and market capitalization, but
positive relationship with price volatility, and all the coefficients for test sample show
insignificant change after conversion.

Further research: the determinants of bid-ask spread and its components in NASDA
after decimalization and changing in the tick size, since all of the previous studies
were conducted under fractional pricing.

Inventory and adverse selection costs display insignificant net changes after
decimalization and this is either the effect of the larger discrete grid on traders’
incentive to gather information is small or the various effects discussed in the
introduction offset each other

The reduction in inventory and adverse selection is not because of the pervious
methodology but because of the increase in the order-processing cost components in
spread so more understand is needed to understand the inventory and adverse-
selection costs of market making and the means by which they can be mitigated.

True Spreads and Equilibrium Prices

Clifford A. Ball, Tarun Chordia1
The Journal of Finance
Vol. 56 No. 5 Oct (2001), 1801-1835
Most of previous studies that related to market microstructure use models that ignore
the institutional features of discretization, only recent studies such as (Hausman, Lo,
and Mackinlay (1992), Manrique and Shephard (1997), Hasbrouck (1999a, 1999b))
emphasized the effects of discretization.

1
There is a way in this paper to determine whether the trade is buyer initiated or seller initiated.

19
So in this paper, they explicitly take into account the rounding of prices and quoted
spreads on to a discrete grid in modeling the dynamic behavior of the spreads.

From Trade and Quote database, they used transaction data for seven large stocks for
the Months of February 1997 and November 1997, that is before and after the change
in tick size, where NYSE reduced the minimum price increment form $1/8 (12.5
cents) to $1/16 (6.25 cents) in June 1997. They also obtained the average quoted
spread, number of transactions and the average price from TAQ and ISSM and the
market capitalization from the Center for Research on Security Prices (GRSP).

They used the filters that are used by Chordia et al. (2001), except for deleting the last
and first trade of any day. Moreover, they also studied seven mid-cap stocks in the last
quarter of 1997 to assess the consistency of the results over different classes of stocks
and different times.

The model used by Huang and Stoll (1997) was employed in this study but it is
generalized by allow rounding on to tick grid, allow the true spread to vary, and allow
the prior trade size and market depth to impact the spreads in a continuous fashion.
They also used the Monte Carlo Markov Chain (MCMC) Methodology to handle the
problems of a non-Gaussian state space model, moreover, they developed a structural
model for the bid-ask spread that captures the Known regularities in the data.

They found that, the quoted spreads are significantly larger than spreads that would
prevail without discreteness, which strongly suggest that the effect of rounding on
quote spreads is larger than all the other components of the spread combined. It is
indicated from the significance of the coefficients for the time-of-day dummies that
the true spreads are higher during the first and the last hours of the trading day, they
also found that the reduction in the minimum tick size has a big impact on quoted
spreads but little impact on true spreads.

Regarding inventory and order processing components cost, their result differ form
what found in existing literature, and this is because they estimate the cost
components of spread by taking in account the rounding, but this component still
lower (comparing this result with the result of Gibson et al. 2003) regarding these
components). They also found that the adverse selection component is smaller than
the tick size, suggesting that rounding to the nearest tick provides enough

20
compensation to market maker for the risk of trading with an informed trader, which
indicate that the markets for large stocks are informationally efficient.

Finally, there is much difference in the characteristics of large stocks if compared

with mid-cap stocks and small stocks, for the largest stocks, quoting prices to a
narrower grid would produce much tighter market maker spreads and consequent
lower costs to retail customers.

Further research; using transaction data for Amman stock exchange and make
inferences about the spread from the serial covariance properties of transaction prices.

Another idea, compare the log likelihoods evaluated at posterior means or modes.

The Effect of Decimalization on Trade Size and Adverse Selection Costs

Sugato Chakravarty, Bonnie F. Van Ness, and Robert A. Van Ness.
Journal of Business Finance and Accounting
32 (5) and (6), June / July 2005 0306-686x

Several researchers investigate various aspects related to trader behavior and market
liquidity around the switch to decimalization, and get results similar to those studies
that investigate the effect of change in tick size from $ 1/8 to $ 1/18 in NYSE; that is,
they found that both quote and effective spreads and depth decrease significantly after
the change.

On January 29, 2001, NYSE converted all 3,525 listed issues to decimal pricing after
it was using the fractional pricing of stock. Many of researches that conducted at the
beginning of the decimalization found mixed results regarding market liquidity, so
this study takes a closer look at these results by examining the adverse selection costs
for a sample of NYSE around complete decimalization and compare adverse selection
costs with matched sample of non-decimalized Nasdaq stocks. They also investigate
the relation between adverse selection costs and trade size as a result of
decimalization.

They used a sample of 304 NYSE stocks for the period of January and February 2001,
that is before and after decimalization and obtained the data from NYSE Trade and
Quote (TAQ) database (using tick by tick trade and quote data), also a Nasdaq sample
is used as a benchmark (a sample where the tick size did not change during the study

21
time period), they match each stock in the NYSE sample with its Nasdaq counter part
based on market value of equity, in addition, they filter the data for both markets by
excluding preferred stocks, warrants, and lower class common stocks, Nasdaq issuers
with five-latter ticker symbols, and they follow Huang and Stoll (1996) criteria to
minimize data error.

In this study they expect an increase in the adverse selection costs of medium size
trades and possibly a decline in these costs for large size trade if traders spread their
orders more frequently after decimalization, and also if they informed traders are
staying away from the market, they expect a reduction in a adverse selection costs for
large trades.

To accommodate transactions data they employed the estimation procedures of

George, Kaul and Nimalendran (1991), and Lin, Sanger and Booth (1995) as modified
by Neal and Wheatley (1998). Also they follow Lee and Ready (1991) procedure to
determine trade classification.

They found that an increase (reduction) in the percentage of adverse selection (dollar
adverse selection) costs following the change in pricing in NYSE. And from
estimating the adverse selection components by trade size classes they found that it
declines in trades of all size, with a strong evidence come from trades with medium
size, followed by small and the large trades, finally, a after decimalization they found
that, it appears that there is a less stealth trading and less institutional trading. One
possible reason for the lower adverse selection costs following total decimalization is
the lack of participation by informed traders as indicted by the reduction in large size
trading, and by the lack of stealth trading as evidenced by an changed number of
medium size trades.

Overall, all of these results consider complements to the findings of Chakravarty et al.
(2004) and Bacidore et al. (2003) and also provide a good understanding of the cost of
liquidity on NYSE after decimalization.

Criticize: they depend on a sample of two months on before and one after the change
and this only reflect the effect of decimalization for short-term.

Idea: many of studies that study the effect of change in NYSE like Chakravarty,
Wood and Van Ness (2004) and Bacidore, Battatio and Tennings (2003) they show

22
decline in depth but it doesn’t clear that this decline is due to limit orders or due to
lower quoted depth from the specialists.

Look at p1064, p1065, AND p1066.

Informed Trading and the Bid-Ask Spread: Evidence from an Emerging

Markets
Jan Hanousek and Richard Podpiera
Journal of Comparative Economics
31(2003) 275-296

Many of researches focus on the link between informed trading or the adverse
selection of traders and the bid-ask spread, although many empirical studies try to
estimate the components of the bid-ask spread, the size of the adverse selection cost
components is not fully resolved and the differences of estimating adverse selection
are difficult to explain because these studies differ both in data and estimation
methodology.

Most of recent studies suggest, in developed markets, that the share of the adverse
selection components is rather low, in addition, most of previous studies conducted in
this topic dealt exclusively with U.S markets and, except for recent studies, have
depend on daily and weekly data. So this study investigated the Bid-Ask spread in one
of emerging markets which is Czech Stock Market, focusing on adverse selection
component, this study also offers an insight into the magnitude of the adverse
selection component in a market known for being plagued by insider trading. In this
market the regulations lagged significantly, but in recent years they are improved, but
enforcement still appears to be rather weak, and this market still offer wide latitude
for informed and insider traders to transact on anon-public information. In addition,
the trading system (SPAD trading system) in Czech market provide a good
opportunity for investigate the Bid-Ask spread.

The sample period in this study ranging from March 1999 to the end of December
2001, and include 10 stocks, six of them were traded without any significant
interruption, also the market makers did not vary during the sample period, each on of
these stocks had, on average, 9 market makers. The trading system operates under two
phases the open and the close, but they focus on the open phase in the analysis. Data
on individual trades have been publicly available since early 1999, and for the 34

23
months in their sample period, they have information about each transaction in the
SPAD system. For each trade, they know the stock identification, transaction price,
number of shares, time of the trade and the best bid and ask quotes. And they were
able in this study to distinguish cross trades.

Because most of dealers engage in inter dealer trading they include a binary variable
(PRESS), which indicates whether a particular trade happened in a period of selling or
buying a pressure, they also include CROSS variable to indicate cross trade, and the
rational behind including this variable is that some trades might be viewed by the
market as having different informational content that normal trades.

They used the model of Huang and Stoll (1997) to get their estimations about bid-ask
spread and they modify it to account for the inventory behavior of dealers in a
multiple-dealer trading system. And they used generalized method of moments
(GMM) because it imposes very weak distributional assumptions and allows us to
account for autocorrelation and heteroscedasticity.

Their results and estimation of the bid-ask spread components suggest that the
adverse selection component amounts to only 17% which is very low given the
evidence of wide informed trading in this market and they found that all the
estimation for this component are statistically significant. They also found that
inventory component accounts for 6% on average and it is ranged from 4% to most
liquid to 13% for the least liquid stocks which confirms that market makers asking for
high premia for holding inventories and the remaining 77% account for order
processing cost.

They explained the lower adverse selection components by the observation of the gab
between the posted and traded spreads, that is more than one third of spread was
waived because market maker want to offer better prices for their counter parties than
the posted bid-ask quotes, that is, the growing experience and limit size of the market
allow market maker to discriminate between counterparties and lower their loss to
informed trader, finally, it is appeared that this market appears to be rather efficient in
dealing with informed trading

24
Criticize: the sample used in this study depend only on 10 stocks where six of them
are the most liquid so they can’t generalize the results to the overall market, they
should take as many stocks as possible.

The effect of Information Asymmetry on Bid-Ask Spreads around Earnings

Announcements by NASDQ Firms
Samuel Tung
Review of Pacific Basin Financial Markets and Policies
Vol. 3 No.3 (2003) 331-346
One of the streams of accounting research is the reaction of accounting earnings
announcements; this kind of research tries to understand the usefulness of accounting
information for investors. Most of research focused on stock price and trading volume
reactions to accounting disclosure, and since accounting information could be useful
to investors without affecting prices or volumes, one useful research question is how
accounting disclosure affect information asymmetry (which is reflected by the adverse
selection cost components of bid-ask spreads). So most of researches provided limited
empirical evidence and have produced conflicting results from analyzing the effect of
earnings announcements on information asymmetry and the behavior of bid-ask
spreads around earnings announcements.

So this paper examined the impact of information asymmetry on bid-ask spreads

around earnings announcements, that is, it tested Kim and Verrecchia’s (1994) theory
that bid-ask spreads may increase around earnings announcements when information
asymmetry increases between the less informed market makers and the informed
traders.

The importance of this study comes form the fact that this paper provides empirical
evidence on the behavior of bid-ask spreads and its relationship with information
asymmetry around earnings announcements and it is relevant to accounting policy
makers and practitioners because it make it easy to understand how accounting
information affects the stock market by increasing market liquidity and by reducing
information asymmetry and bid-ask spread.

Compared with previous studies that used different proxies for information
asymmetry (i.e Atiase and Bamber 1994, Bamber et al. 1997), in this study the author
used the percentage of common stocks held by institutional investors as empirical
proxy for information asymmetry between the traders and the market makers, he also

25
included a dispersion in analysts earnings forecasts to see which are can better capture
information asymmetry.

He depend on a sample of 433 annual earnings announcements by Nasdaq National

Market system companies during 1992-19941, these data are commercially available
from sources mentioned in the text.

By using these data, this study test two hypotheses to provide empirical evidence,
these hypotheses are:

“H1: Bid-ask spreads are higher at the earnings announcement dates than at non-
announcement dates.

H2: The magnitude of bid-ask spread reactions to earnings announcements is

positively related to the level of information asymmetry.”

To assess whether mean daily abnormal spreads during the announcement period are
significantly greater than zero, this study used t-tests. According to the results, bid-ask
spreads increase significantly on the day of the earnings announcements, and increase
further on the next day, but go back to be insignificant on the second day and
thereafter except for the fourth and sixth days after the announcements. And this
consistent with KV’s proposition that at the time of earnings announcement the bid-
ask spread increased, but they found weak evidence about the conjecture that market
makers are likely to increase bid-ask spread in anticipation of earnings announcement
to protect themselves against traders acting on leaked information.

Moreover, they found that the increase in bid-ask spread is positively related to the
information asymmetry, as measured by the percentage of institutional ownership,
which is consistent with KV’s theoretical proposition, this association still hold after
controlling for the effects of other cross-sectional determinants of spreads.

Criticize; this paper depend on a sample during time period that is very old compared
with the date of the study which mean that during this gap in time period between the
date of sample and the date of study many things happened to the nature of the market
so such results may be inapplicable unless it is confirmed by more recent study.

1
Firms in this sample should meet a specific criteria to see this criteria look at the paper page 334-335.

26
Idea: applying the same idea of this study but on newly data (recent data with in
recent time period)

Inferring the Private Information Content of Trades: A Regime-Switching

Approach
Ken Nyholm
Journal of Applied Econometrics
18: 457-470 (2003)
The previous empirical models about market microstructure impose too crude
restrictions on the behavior of the specialists, that is, these models assume that the
costs incurred by specialists (posted spread) are fixed and this assumption is used
since the details about the trader’s identity, reputation, and the atmosphere on the
floor are not directly available to econometrician.

So this paper used the estimation technique and a model that utilize such unobservable
information to infer the specialist’s belief about the information content of each trade.

In this study two reaction patterns of specialists are modeled; if the specialist thinks a
trader revealed a private information about the fundamental value of the stock, they
made a large reversion of the quote midpoint or may be the spread is widen, and if the
specialist think that the last trade was initiated by a trader possessing little or private
information their will be a minor mid quote revision or no revision at all. The model
used in this study is the trade indicator model suggested by Glosten and Harris (1988)
and reviewed by Huang and Stoll (1997), this model is expanded to include
unobservable indictor variable encompassing the quote revisions relating to the first
reaction in specialist behavior.

Econometrically, the regime-switching technique1 which is suggested by Hamilton is

used to estimate this model, using tick-by-tick data.

The stocks used in this study is the same as the stocks used by Huang and Stoll
(1997), the twenty stocks that are the most active (frequently traded) in NYSE, and
the data about these stocks are obtained from the Trade and Quote database.

The results show that 9% of the trades of the 20 NYSE stocks analyzed are initiated
by privately informed trader; also the reverse J-shaped intra-day pattern of quoted
spreads is correlated with the intraday pattern of the estimated probability of informed
trading. Moreover, an evidence for the stealth-trading hypothesis of Barclay and

1
To know more about this technique see Hamilton 1994.

27
Warner has been provided by the volume-dependent version of the regime-switching
model.

Finally, the specialist is found to react in accordance with the proposed model and
bid-ask quotes set after the execution of a trade reflect the conjectured information
content of that particular trade.

Information Asymmetry Around Earnings Announcements: A Simple Model to

Decompose the Bid-Ask Spread.
Gerhard Kling
Utrecht School of Economics.

Most of the studies related to earring announcements try to know how earnings
announcement affect stock price and lead to abnormal returns. And also try to focus
on the interrelation between earnings announcements, different forms of disclosure,
analysts’ forecasts and abnormal returns, but this paper focus on analyzing the market
reaction triggered by earnings announcements on the bid-ask spread of companies,
that is the scope of this study is to assess the change in information asymmetry around
earnings announcements, which is measured by information cost components.

In this study, the data set contains intra-daily transaction prices, bid-ask quotes and
the number of traded shares for two months October and November 2000, and he
draw 20 stock randomly, this sample meet 3 requirements; the stocks should be listed
in Nasdaq, the forecast for its earnings per share of the third quarter (end in
September) are available from Thomson Financial I/B/E/S, and at least ten trades
should occur each day.

He followed in this study Krinsky and Lee (1996), decomposition technique to

quantify the degree of information asymmetry around the day of an earnings release,
but he distinguish between good news and bad news, and also his model provided
more insights into the cost components of the spread. He also drove the trade indictor
model from the general model of Huang and Stoll (1997).

From testing the five days surrounding the event as a whole, it is appeared that these
days don’t exhibit different components in comparison to a reference day. He
concluded that within the five days around charges in information asymmetry
triggered by announcements is short-term phenomenon. Also he found that news that

28
deviate considerably from expectations increase information asymmetry. In addition,
the results show that the model provide estimate to the two source of information
asymmetry (liquidity and trading volume). And around the announcement date the
information costs increased in a narrow range. He found also that if the company
declares that the earnings are so far above or far below their forecasted values.
Liquidity drops on the event day sharply, which can be interpreted as the dealer
believe that the order stream conveys more information than on normal days,
moreover, one day before the announcement the average trading volume per
transaction increase significantly regardless the expectations are met or not, and the
contribution of higher average trading volume to upsurge in information costs is lower
than the decline in liquidity.

Finally, his model was able to separate both sources of information asymmetry and
quantifies their relative importance, and the empirical results showed that trading
volume and liquidity should increase and decrease respectively in the presence of
earrings announcements.

Criticize: the model used in this study ignore the inventory cost components, even
many of previous studies showed that this components is very important and
contribute to bid-ask spread.

The Effect of Board Meetings on Bid-Ask Spread for Firms with Concentrated
Insider Ownership
Suchi Mishra, Wei Rowe, Arun Prakash

Most of studies that have been conducted linked between market microstructure and
corporate finance, and they focus on the information asymmetry following
informative corporate events such as stock splits, reverse split, stock repurchase and
corporate acquisition announcements and the effect of these events on bid-ask spread.
Working on the same path (the effect of corporate finance events on market
microstructure) this study based on established association between bid-ask spread
and insider ownership to study the information asymmetry around the board of
director’s meetings. Since the exact days of meetings are not known, then it will be
interesting to see the change in spread surrounding the dates of board of directors’

29
meetings in firms with concentrated insider ownership ( when the voting shares held
by directors and officers exceed 10% of its total shares outstanding the firm consider
with concentrated insider ownership). In other words, since the current SEC
disclosure rules only require companies to disclose only the frequencies of annual
board meetings but not the meeting dates, so the question is are these meetings
consider only day-to-day routine events or are they important informational events
instead that deserve more attention from regulators and investors? Also is there
information asymmetry or informed trading surrounding the board of director’s
meetings.

They used hand-collected data of board meeting dates for firms with concentrated
insider ownership and basing on the criteria of concentrated insider ownership a total
of 235 companies have met their sample selection criteria, after e-mails sent to collect
date and phone contacts to follow up, the response rate was 19%.

They used closing quotes of bid and ask from the trade and Quote (TAQ) database,
after dropping some dates the dataset contains 166 boards of directors meetings dates
for 40 companies. They employed in this study two event study techniques, in the first
one they followed Chung and Charewong (1998) and assume the intertemporal
behavior of spread as a stochastic process. In the second one they conduct a variance
event study surrounding the event. Since a higher variance surrounding the board
meeting date will be evidence for informed trading leading to higher uncertainty.
Moreover, in order to determine whether the widening of spread is due to the actual
trading by insiders, they look at the insiders trading activities surrounding the board
meeting days.

They found, as is inferred from the significant spread changes in the event study
results that informed trading does exist surrounding the board meeting dates. They
found also, consistent with the results of Stoll (1997) that total risk increase around
the event time which reflect in the size of spread, moreover, they found that after the
board meetings the insider trading activities increased and these specialists still able to
recognize the informed trading by those insider which result in increasing the spread.
This suggests that board meetings may be highly informative corporate events.

30
 Note Explaining the Intra-day Variation in the Bid-Ask Spread in Competitive
Dealership Markets – A Research Note
Eric J. Levin, Robert E. Wright
Journal of Financial Markets
2 (1999) 179 – 191

Many of studies tried to study the intra-day behavior of bid-ask spread (inside bid-ask
spread (IBAS) and average bid-ask spread (ABAS)) in competitive dealership
markets. And they found a decline in inside bid-ask spread and other found no intra-
day variation in the average bid-ask spread.

This paper tried to document differences in time-series variation between the IBAS
and ABAS and relating results to a number of hypotheses about the cause of intra-day
variation in the IBAS, and they also examine in this study the empirical evidences
regarding the ability of the market-makers to widen the spreads at which they are
willing to trade with out widening their posted spreads.

They classified the explanations for variation in the ABAS into two groups, the first
one include four situations that require that market maker to expand spreads at
different times; informed trading, price inelastic market demand, price discovery and
market concentration, while the second group include inventory control and statistical
artfeact under which the market-maker don’t vary spreads.

This study depend on the market-maker’s buy and sell quotations with start and end
times during each trading day between August 1994 to the end of July 1995 for 100
equities in FTSE 100 index, these data are obtained from SEAQ, only stocks with
normal market size are included in analysis.

They found that market makers don’t systematically widen their bid-ask spreads at
particular times of the trading day, and no theories for understanding the observed
intra-day patterns in the IBAS has obtained from the explanations that base on the
ideas of market concentration, informed trading, price inelastic market demand and
price discovery. The explanations that don’t require the market makers to widen their
spread at particular times of the trading day will base on the idea of inventory control.

Finally, these conclusions are tentative since the examination of the data don’t provide
empirical support that the ABAS provides reliable measurement of the average of the
bid-ask spreads at which market maker are actually willing to trade, this suggest that

31
market makers may be able widen their bid-ask spreads without widening their posted
bid-ask spreads. So no general conclusion can be reached regarding the relationship
between the shapes of the ABAS in the explanation of intra-day variation in the
IBAS.

Criticize: this analysis in this paper based only on simple statistical measurement (the
average of spread) and the behavior of this average, no models are tested or
relationships between variable to give any empirical evidence.

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

Nicolas P.B. Bollen, Tom Smith, Robert E. Whaley
Journal of Financial Economics 72 (2004) 97-141

Previous researches have made substantial progress toward understanding the

determinants of bid / ask spread, which is consider very important to understanding
and evaluation the merits of market structure and the fairness of market maker rents.
So the earlier work focus on determining the variables that capture the cross-sectional
variation in spreads and all of the previous studies made significant contributions to
understanding this part of trading cost (bid-ask spread), but still unsolved issue is the
functional form of the relationship between the explanatory variables and spread.

Since the structural form of the model is very important, this study aims to develop
and test a new model of the market makers spread because most of previous models
were developed through economic reasoning instead of formal mathematical
modeling. The model that is developed in this study is consider simple, parsimonious
and well grounded from a theoretical perspective, which is also incorporate the price
discreteness effects that induced by the order processing cost, inventory-holding costs,
adverse selection costs, the minimum tick size, and competition. Moreover, this model
identified the structural relation between bid/ask spread and its determinants, and it is
consistent with the presence of an exchange-mandated tick size. The model of

32
inventory-holding premium is sufficiently rich so one can estimate the probability of
informed versus uninformed trades across stocks. Both inventory-holding and adverse
selection cost components of bid/ask spread are modeled as an option with stochastic
time to expiration. The price risk borne by the market maker while holding securities
is compensated by the inventory holding premium embedded in the spread.

Using NYSE’s Trade and Quote (TAQ) data files, they used only Nasdaq stocks
because the information on the number of dealers is only available for this stock
exchange and not available for NYSE and AMEX stocks. Data for three separated
months are used to assess the ability of the model to identify the minimum tick size
prevailing in the market; these months are March 1996, April 1998, and December
2001. The minimum tick size prevailing in the market differs during these months.
For the first two months in the sample, stocks that are traded at prices less than an
eighth in March, 1996 and less than sixteenth in April, 1998 were eliminated from the
sample. In this study they match the quotes prevailing immediately prior to the trade
and then six summary statistics for each stock each day have been computed; the
number of trades, the end-of-day share price, the equal-weight quoted spread, the
volume weighted effective spread, and the average time between trades. Even past
studies used the quoted spread; this study used equal-weighted average of the spreads
appearing through out the day. Moreover, they remove the effect of outliers; they also
include in the sample only the stocks whose share traded at least five times each day
every day during the month (118 ‫ ) اضافة بعض المقاييسس صفحة‬.

From the data used, the summary statistic shows that moving to a smaller tick size has
reduced the quoted spread (consistent with Bessembinder 2003, with Chung and Ness
(2001), Bessembinder (1999), and Weston (2000)), also their was a reduction in the
levels of the volume weighted effective spread, and large number of trades were
executed at prices within the prevailing bid/ask quotes as indicated by the large
difference between quoted and effective spreads. The regression results using quoted
spread as dependent variable indicate that the inventory holding premium is the most
important explanatory variable and the competition among market makers play an
important role in determining the absolute level of the bid/ask spread, moreover, the
magnitude of he coefficient of trading volume in each month indicate that fixed costs
of market making have been reduced, and finally, the intercept was equal to the
minimum tick size. The same results are obtained when using relative spread as

33
depended variable when using ad hoc model specification 1 the results show that all of
the variables are significant in a statistical sense, and the adjusted R-squared levels are
less than for the properly structure model. Moreover where modeling inventory-
holding premium as a collar and then as straddle, the results indicate that the
regression performance of the collar model continues to dominate. In determining the
component of bid/ask spread, the results show that bid/ask spread contain four cost
components; tick size components, inventory holding cost component “which is the
dominant one in all three sub samples”, competition and finally the smallest
component which is adverse selection. Finally, it has been shown according to the
model that the bid/ask spread is a function of the minimum tick size, the inverse of
trading volume, competition among market makers, and expected inventory-holding
premium.

Quote setting and Price Formation in an Order Driven Market

Puneet Handa, Robert Schwartz, Ashish Tiwari
Journal of Financial Markets 6 (2003) 461-489

A great attention of researches have been directed to order driven markets due to new
order handling rules of the U.S Securities and Exchange Commission; the
developments of SuperMontge in NASDAQ; the growth of new electronic
communication networks; and the development of electronic limit order book trading
platforms in virtually all of the markets centers in Europe. This study direct the
attention to new structure of markets, that is, it is focus on Non-intermediated order
driven market.

They model quote setting and price formation in this type of market. And this model
an extension of Fucault (1999) where investors share valuations for a security differ,
so they examine the impact of asymmetric information on posted bid and ask prices;
they aim to analyze the determinates of the bid-ask spread in an order driven market,
and their main contribution in this study is to test the empirical implications of the
extended Foucault model. (Comparison between their model and Foucault model p
463)

1
Including share price, return volatility, the average time between trade, the inverse of trading volume,
and the modified Herfindahl index as a determinants of spread.

34
Depending on ParisBourse Base de Donnees de Marche data base, they examine the
stocks that comprise the CAC40 index, which is based on a sample of 40 French
equities that are selected from the top 100 market capitalization firms on the RM
section of the market.

The data base consist of an order file, which include information on both market and
limit orders for each stock of the CAC40 for one year period (1995). They perform
test of the model basing upon the generalized method of moments (GMM) proposed
by Hansen (1982), also they employ five instrumental variables for estimation and
testing which include a constant term and four lagged values of the imbalance
parameter K.

They found that in order driven market the location of the bid and offer quotes and the
size of the bid-ask spread depend on the difference in the valuation among groups of
investors, the proportions of investors in each of the groups and adverse selection. As
the difference in valuation between groups of investors increase, the spread widens,
and it will be at maximum when the proportion of investors in the two groups is
equal. Moreover, their analysis provide further insights into the market clearing
process, if the natural buyers out number natural sellers or vis versa, the market would
not be able to clear with out a dealer intermediating as a seller or buyer of shares.
Finally they found that the order driven market rations itself as participants resolve the
tradeoff between accepting non-execution risk and paying the bid-ask spread. In this
type of markets the bid and ask quotes are set at a level that just induce enough
participants to accept the risk of non-execution and save paying the bid-ask spread by
placing limit orders.

35
 Estimating the Profit Markup Component of the Bid-Ask Spread: Evidence
From the London Stock Exchange
Eric J. Levin, Robert E. Wright
The Quarterly Review of Economics and Finance
44 (2004)1-19

As known from previous studies that the bid-ask spread consist from four cost
components the order-processing cost, inventory holding cost, adverse selection cost,
and finally market-maker rent or economic profit. The first three components have
been identified and calculated by many scholars (see the references sited in this
study), and regarding the fourth component many of studies provide empirical
evidence for this component (see the references cited in this study), but the empirical
findings of this component “dealer rent” have not been checked against the limits
implied by economic theory, so this paper focused on this component of bid-ask
spread since the evidence about this component (market-maker rents) is less clear in
the London Stock Exchange, and examine the theoretical basis for a relationship
between empirically observed bid-ask spreads and the theoretical excess profit
markup of industrial organization theory where the profit-maximizing selling price is
the ask price and the marginal cost is the bid price.

In this study they analyze the relationship between market structure and price
sensitivity for the excess demand curve for stock in order to ascertain the economic
profit component of the bid-ask spread implied by the theoretical excess profit
markup. And it is based on the assumption of a Cournot-Nash equilibrium to present
the empirical analysis, and this assumption represents a non-cooperative equilibrium
so the estimates of the profit component of the bid-ask spread based on this
assumption can be regarded as conservative or lower bound estimates, since any
collusion will lead to larger profit markups. Moreover, the model used in this study to
estimate the profit markup component of the bid-ask spread requires an estimate of
the slope of the excess demand curve which in turn, require the use of a model of
Glosten and Harris (19880 and Hasbrouck (1991).

The sample period covered in this study was from 1/8/1994 to 31/7/1995, and the data
consist of a total of 9,054,352 normal transaction records for the 100 stocks that make
up the FTSE 100 share transactions on the LSE after removing records that are not

36
relevant to aggregate market maker inventory such as header records, cash
adjustments, stock loans, and settlement adjustments. After filtering the records the
remaining number of records is 76,976 represent 38,488 transactions between dealers
who were not market makers.

Depending in ordinary least square method employed to estimate the parameters of

regression using the transaction data, they found that under Cournot-Nash equilibrium
in which each dealer expects a zero rival sales volume reaction about 11% of the
observed bid-ask spread is attributable to an excess profit markup (small but
economically significant), and the remaining 90% of the observed bid-ask spread
appears to be attributable to execution costs, inventory control costs and adverse
selection. Any collusion among dealers would imply that a larger proportion of the
observed bid-ask spread represents excess profit. Also the estimation of the price
elasticities of demand for individual stocks in this paper is consistent with the findings
of Weston (2000) for Nasdaq, and their estimates of the rent component lie within the
limits implied by economic theory assuming collusion among Nasdaq market makers.

Criticize: look at the problem related to the data

Ideas: look at the end of page 14

37
 The Components of the Bid-Ask Spread in a Limit-Order Market: Evidence
from the Tokyo Stock Exchange
Hee-Joon Ahn, Jun Cai, Yasushi Hamao, Richard Y.K. Ho
Journal of Empirical Finance
9 (2002) 399-430

A great attention have been focused on limit-order trading as more exchanges

implement electronic public limit-order books and open up the market-making
process. Many of studies examined different aspects of the limit-order market, and
many of previous studies have been conducted within the framework of quote-driven
single (multiple) dealer markets. So this study come to examine the aspect that related
with bid-ask spread, that is, it is examined the components of bid-ask spread in a
limit-order market which is Tokyo Stock Exchange (TSE), in this market there is what
called a saitori maintains each offer to buy or sell in an order book that is open to all
exchange members on the floor, and every transaction is executed by them. And also
this market is different from NYSE in that it hasn’t separate venue for block trading
where traders can negotiated for their trades.

In this study, they obtained trades and quotes data from Nikkei Economic Electronic
Database System historical tick data, and the sample period is ranging from January 5,
2000 to March 31, 2000, for a total of 60 trading days. The initial data set was subject
to filtering process which ends up with 204 firms in the final sample; these stocks
include 171 stocks within the price range of less than ¥2000, 11 within the price range
of ¥2000 to ¥2999, and 22 within the range of ¥3000 to ¥29,999. So they group them
into three groups as following: Group 1 (under ¥2000), Group 2 (¥2000–2999), and
Group 3 (¥3000–29,999) stocks. Since there are two trading mechanisms is this
market itayose and zaraba1, they used the transactions made under the zaraba.

They used in this study the framework developed by Madhavan et al. (1997) or MRR
model, which can be applied to the study of bid–ask components in an order-driven
market like TSE. This approach or model has characterized by having its belief that
inventory costs are of a less important concern for limit-order traders, if it is compared
with the NYSE specialist who is obliged at all times to maintain inventory positions
on both sides of the market. And since the estimation results might be sensitive to the
1
In Tokyo Stock Exchange the opening and closing transactions in each session are made under a batch
clearing process called itayose while the rest of the trades during the day are made under a continuous
double auction called zaraba.

38
specifications used by different market microstructure models. They used other
models such as De Jong et al. (1996) model, the Glosten and Harris model (1988), and
the Hasbrouck’s Vector Auto Regressive (VAR) model (1988, 1991a,b) to cross-
validate their estimation results.

They used the generalized method of moments to estimating the parameters in the
Madhavan et al. (1997) model, and when the estimate the parameters of other two
models (De Jong et al. (1996) model, the Glosten and Harris model (1988)) they used
the ordinary least squares.

According to the results they found that, both order-processing and the adverse
selection cost components exhibit U-shape patterns independently, which implies a U-
shape pattern in the implied spread. This is in striking contrast to the finding by
Madhavan et al. (1997) for NYSE stocks that the adverse selection component
declines and dealer costs increase over the trading day, resulting in an overall U-shape
of the spread. This suggests that transactions around end of the trading day convey
private information that would otherwise be released during the nontrading hours that
follow the exchange close. They also found that, order processing cost decreases with
trade size and the adverse selection component increases with trade size. The evidence
is consistent with the practice of handling large trades on the TSE since there is no
exist for upstairs trading TSE. In contrast, large trades are often prenegotiated through
the upstairs markets, and this often leads to smaller adverse selection costs associated
with large trades. Their findings are robust to the choice of different market
microstructure models because of the striking U-shape pattern of the adverse selection
component of the spread and the positive relation between trade size and
informativeness of a trade.

Idea: As expected, the spread component estimation is sensitive to model

specifications. The estimates of the adverse selection (order handling) component
from the two alternative models are generally lower (greater) than our estimate from
the MRR model. So these models give different estimation why don’t try to reconcile
these models to have another estimation.

39
 Components of Execution Costs: evidence of asymmetric information at the
Mexican Stock Exchange
Ana Cristina Silva and Gonzalo Chavez
Journal of International Financial Markets, Institutions and Money
12 (2002) 253-278

The cost of execution to immediacy demanders is known in financial markets by the

difference between the ask and bid price. Since this cost reduce the returns to
investors and because of the competition for order flow between security markets, it is
important to gain a well understanding to the nature of this kind of cost and how
market structure affect this cost. More over, one of the important characteristics of
emerging markets in Latin America is the higher trading costs which result in losing a
lot of business to more mature and liquid markets (i.e. the migrating of trading in
Latin stocks to the US markets as more of the firms are listed as American Depository
Receipts,

So this study aimed to investigate and analyze the effect of market structure on the
trading costs in one of Latin American Stock Exchange which is Mexican Stock
Exchange which is, like other stock markets Tokyo Stock Exchange, and the Paris
Bourse, rely on investors placing limit orders for the provision of immediacy. They
tried through this paper to answer the following questions:

“Are these costs related to a lack of competition among market participants? Are they
related to trading restrictions on exchange members that limit their ability to handle
inventory? Are they related to a regulatory framework that does not protect the
uninformed trader?” (p. 255).

The sample period covered the last 5 months of the year 1994 ( 105 trading day from
August to December), and information about the 42 most active stocks contain a
record of trades for these stocks were collected electronically by the MSE, also they
have the daily closing bid and ask quotes. And because of some elimination the final
Mexican sample consists of 37 issues (29 firms). They also obtained a matched
sample of NYSE stocks contain intraday quote and price information about these
stocks. For matching method they employed the same way used by Huang and Stoll
(1996), so for each MSE issue the NYSE match is the stock that yields the minimum
score.

40
 They applied the method used by Stoll (1989) to infer the components of the spread
from the serial covariance of transaction and quote prices, even it consider an old
technique but it has the advantage of allowing a decomposition of the spread into its
three components by using daily quotes.

The results show that, asymmetric information costs are 95% of the spread, inventory
costs are 4%, and order processing is 1%. For NYSE stocks, asymmetric information
costs are 52%, inventory costs are 33%, and order processing costs are 15%, so the
results support the first and the second hypotheses and contradict with the third one 1,
that is, there is a difference in spread components between two exchanges. So their
results show that asymmetric information accounts for most of the cost of trading at
the Mexican market. Then after matching a new sample of MSE with NYSE which
they are closely matched for trading volume and return volatility, they found that the
asymmetric information differential persists and the inventory holding cost
differential is accentuated. Finally, when they take in consideration the possible effect
of other issues such as number and sophistication of security analysts, listing and
disclosure requirements, ownership restrictions, and voting rights they found that the
difference in asymmetric information are not related to these issues.

Research idea: Our results also provide a basis for further microstructure research.
First, high asymmetric information costs at the MSE may constitute an implicit
investment barrier. This is consistent with previous research documenting a lack of
integration between emerging and developed economies (Harvey, 1995; Bekaert,
1995) and between the Mexican and US markets (Domowitz et al., 1998). The role of
asymmetric information in market segmentation is yet to be fully explored. Second,
comparing the spread components of financial assets with similar characteristics, but
immersed in different trading environments, sheds light on the issue of market
microstructure selection. However, further work is needed since a true comparison of
trading mechanisms must first account for other differences in market characteristics,
such as the level of insider trading. Recent evidence of unrestricted insider trading at
the MSE (Bhattacharya et al., 2000) would seem to support this concern.

Note; try to have a look and understand the bootstrap hypotheses.

1
These hypotheses in page 258-259 in this paper.

41
 Infromatin Flow, Volatility and Spreads of Infrequently Traded Nasdaq Stocks
Chunchi Wu
The Quarterly Review of Economics and Finance
44 (2004) 20-43

Despite the large body of literature that conducted in market microstructure field, few
studies have examined the sources of intraday price volatility and trading costs of
infrequently traded stocks. Studies that related to information flow have focused on
either actively traded NYSE stocks or aggregate market indices (e.g., Lamoureux &
Lastrapes, 1990, Andersen & Bollerslev, 1997a, 1997b, 1998; Andersen, 1996;
1994; Richardson & Smith, 1994). In addition, there is a difference in the price
discovery process and bid-ask spread behavior of Nasdaq stocks and those of NYSE
stocks (see Hasbrouck, 1995; Huang & Stoll, 1996). And since the area of information
content of trades and the dynamic relationship between price changes and information
flow of small, infrequently traded stocks not covered too much by previous studies,
this paper examined the intraday pattern of information flow and its effects on return
volatility and trading costs of infrequently traded stocks in the Nasdaq market.

Moreover, It is also important to note that the differences in market structures and
trading mechanisms may cause variations in trading costs, order flows, and the speed
of information transmission (see, e.g., Affleck-Graves, Hegde, & Miller, 1994;
Hasbrouck & Schwartz, 1986; Marsh & Rock, 1986; Stoll, 1976, 1978). An
opportunity for analyzing the intradaily variations of information flow and the extent
to which trades convey information for frequently versus infrequently traded stocks
has come out because of the feature of Nasdaq stock exchange regarding the depth of
the market which is often varies widely among stocks.

He obtained the data from the TAQ database which is on price, size, and trading time
for Nasdaq stocks and cover the period of July 1 to September 30, 1997. Short-term
period has been chosen because the stationarity of volume and return series is very
important for the estimation of the mixture of distribution model. Transaction data for
each trading day are divided into 13 30-minutes intervals, and to avoid the problem at
the market open data for the first 10 min of trading is excluded. The sample has been
divided into volume deciles after rank all Nasdaq common stocks by the average daily

42
trading volume over the sample period, and only three out of ten deciles have been
chosen for the purpose of empirical estimation which are the first, fifth, and the
eighth.

This study use the Andersen’s (1996) modified MDH model, which has proven quite
successful for extracting the information content of trades in addition to many
advantages1, and the generalized method of moments (GMM) is used to estimate the
MDH system from the return sand volume data, and then it estimate the cross-
sectional regression model that test the relationship between bid-ask spreads and
informed trading and also the cross section regression that test the relationship
between return volatility and information flow.

We find that the proportion of information-based trading is negatively correlated with

trading activity, that is, a higher percentage of informed trading is associated to
Infrequently traded stocks which in turn translated into much higher bid-ask spreads
for this class of traded stocks. He also found that effective bid-ask spreads are a
positive function of the percentage of informed trading as indicated from the results of
cross-sectional regression. So the differences in bid-ask spreads among stocks largely
reflect the intensity of informed trading.

In addition, he found that return volatility is positively related to trading

Volume, this positive relationship is derived from the effect of informed trading on
return volatility. Moreover, the sensitivity of price of infrequently traded stocks to
informed trading is higher than that of frequently traded stocks, which is suggests
that information arrivals have a larger impact on price movements of infrequently
traded stocks.

Finally, a negative relationship has been found between the liquidity volume and
return volatility, which supports the contention that greater market depth reduces
return volatility and increases price stability. In other words for frequently traded
stocks the effect of liquidity trading on return volatility tends to be greater. He found
that empirical studies of market microstructure which used volume as an explanatory
variable for return volatility have substantially underestimated the effect of
asymmetric information, which suggests that the total volume is a very noisy proxy
for private information.
1
See page 22 in this study.

43
Idea: applying the following hypotheses on LSE which are that the informed trading
component will have a positive relationship with return volatility and bid-ask spreads,
and that these positive relationships will be stronger for less frequently traded stocks.

- The results of the regression using the price impact as a dependent variable shows
that the coefficient of the intensity of information-based trading γ is positive and
significant at the 1% level. The result also indicates that the price impact is highly
correlated with the intensity of informed trading. The coefficient of volume is also
significantly negative. The cause for this significant relationship is not immediately
clear. It is possible that either volume is noisy proxy for inventory cost or price impact
is an imperfect measure of adverse information cost. Searching this.

You should know what is : the law of iterated expectations

** Method suggested by Lee and Ready (1991) for trade classification and also the
tick size test in page 26.

Criticize: most of the socks in the sample are subject to the new trading rules in
Nasdaq which is the change tick size or decimalization and according to previous
studies this change will affect the bid –ask spread.

Another criticizes the failure to account for the liquidity volume effect results in
downward biased estimates of the information effect on volatility.

The Components of the Bid-Ask Spread: The Case of The Athens Stock
Exchange
Timotheos Angelidies and Alexandros Benos

44
 January 13, 2005

The results of Huang and Stoll (1997) about the large presence of order processing
cost components and a smaller adverse selection and inventory cost components, also
that the spreads are depending on trading volume (the same conclusion is reached by
Ahn et al. (2002)), give the insight for this paper, which goes to provide an empirical
application to a small electronic order book, moreover, the Athens stock exchange
(ASE) lends itself to such an exercise because a lot of listed stocks trade very
passively for long periods during the day, making the information asymmetry
included (contained) inside the sign traded volume a more important factor than either
the trade or the volume individually.

So by using Madhavan et al. (197) model, this study aimed to; first incorporate traded
volume in this model as extension (to examine the idea proposed by Ahn et al. (2002))
and estimate it for several time intervals to simultaneously investigate the “time-of-
day” effect, and second, studying the price impacts caused by different factors, such
as trade volume, market capitalization and order flow dependence.

This study depend on high frequency transaction level data drawn from intraday files
of the ASE for the period from February 4, to December 30, 2002, these data contains
the time-stamped prices to the nearest second, volumes and bid and offer prices with
corresponding sizes just before a transactions occurs. The sample depend on two
major equity indexes, the FTASE-20 and FTASE-40 which represent the medium and
large capitalization companies respectively, and the stock in each index classified in
two groups, stocks with average sample price is greater than € 10 and those with
average sample price is less than € 10. The data filtered by deleting transaction at the
open, eliminating trades were the bid is greater that corresponding ask, and also those
trades that have error in time stamped has been eliminated.

The classified the trade as either buy or sell oriented as following; if the transaction
price is higher (lower) than the mean of the bid-ask price quotes that the trade is a
buy-side (sell-side). Moreover, they also use a sample of stocks of large-capitalization
included in FTASE-20 index for the period from June 1, to August 31, 1999, this
sample was used to test whether the relations change over time or not.

They found that, in this order-driven stock market the pattern of information
asymmetry is U-shape for all stocks, also for high-priced stocks the cost components

45
exhibits the same U-shape pattern, which it is monotonically inversing during the day.
And this is may be due to the order handling spread component which is more
significant in high-priced stocks, and this explained by the results obtained from a
volume dependent structural model, where it found that the adverse selection increase
with trade size while the cost component decrease, this result similar to those of Ahn
et al (2002). And to get more robust results they estimated the Glosten and Harris
(1988) model, and got the same conclusions. Their results also show that the order
handling component dominates inventory effect. By applying the same test on the
second sample, they found that the cost component accounted for more than 98% of
the implied spreads and adverse selection component was downgraded by market
participants, in that time most of investors had no information about most of stocks,
and the trading was generated from herd behaviour. This difference in results between
two periods 2002 and 1999 is due to large participation of uninformed traders but also
to significant different fundamental background of listed companies.

Finally, in such order driven market, they found from applying two different price
impact functions that there is an economic of scale in trading, with inventory
component being less important that the order processing cost. And also they found
that high price, high capitalization stocks are the most liquid for both price impact
measures. In general, the price changes of high capitalization stocks are less sensitive
to trade size and transaction sequence.

Idea, the model Hasbrouk’s (1991) VAR model, applied in many studies.

And also try to apply the model of Bollen et al. (2004) and try to apply it on London
stock exchange, also applying Madhavan model on London stock exchange or Huang
and Stoll (1997) or any other model to test the component of bid ask spread.

Two studies from this study is about London stock exchange, Berkman et al (2005)
and De Jong et al. (1995)

Bid-Ask Spreads, Informed Investors, and the Firm’s Financial Condition

Vipin Agrawal, Meeta Kothare, Ramesh K.S Rao, and Pavan Wadhwa
The Quarterly Review of Economics and Finance

46
 44 (2004) 58 76

As the firm financial position get worst, this will result in incurring two type of costs
that related to financial distress, which are direct costs (i.e. legal and administrative
expanses of bankruptcy) and indirect costs (i.e. loss of suppliers and customers and
constraints on the firm’s financing and investment opportunities, … etc) in addition to
that, firms in such poor financial conditions suffer from reduced stock liquidity
(increase of bid-ask spread) as demonstrated in this paper.

They argue that as the firm’s performance deteriorated and financial conditions
become worst; there is an increase in the proportion of informed traders in the firm’s
securities. So this paper examined the relation between the financial condition of the
firms and the liquidity of their equity shares as measured by the posted bid-ask spread
by the specialist’s. In other words, this paper tried to find an answer to that question;
is whether the inclusion of variables that consider as proxy for the firm’s financial
condition can significantly explain spreads.

The data used in this study is on stocks traded on the NYSE and AMEX, they obtain
monthly data on price, trading volume, exchange listing, and the percentage bid-ask
spreads form Fidelity Investments of Boston, Massachusetts. On average 2,200 NYSE
listed stocks on NYSE and AMEX are obtained for given month for the period
February through December 1991. The information about the daily returns for each
month and the number of shares outstanding at the end of each month is obtained
from center for research in securities prices daily returns files.

The proxies that used in this study for the firm’s financial conditions are; Tobin’s Q,
S&P bond rating, S&P common stock ranking1, and De Angelo and De Angelo (1990)
measure2.

Because of the outliers they used a median regressions, and after regressing the bid-
ask spreads against the variables that have an effect on spread, then they examine
whether bid-ask spreads can be significantly better explained by the proxies of the
firm’s financial conditions in addition to the control variables, and they also apply
GLS regression to get robustness results.

1
These three proxies are taken form Compustat.
2
See the paper about this measure.

47
From the regression results, they found that all the variable are significant, the Tobin’s
Q is adversely affecting the percentage of bid-ask spread, the firms with high
performance tend to have lower percentage spread that those with low performance
which will have high percentage bid-ask spread, also as debt rating decline from A to
D the percentage spread increase monotonically, which the same for stock ranking.
This is consistent with the notion that as financial condition worsens the percentage of
the bid-ask spread increase.

In other words, the firms with poor financial position tend to have a higher percentage
bid-ask spread, after controlling for factors identified as key determinants of security
liquidity (i.e. price, volume, volatility, inventory turnover). And they argue that an
increase of informed trading in the stocks of firms experiencing financial problems
results in higher bid-ask spread to protect dealers against adverse selection.

Idea, the economic significance of an increase in spreads is required to gain a fuller

understanding of the link between a firm’s financial condition, spreads, and
shareholder wealth.

Another, try to explain the effect of cross listing on bid ask spread for the companies
listed in more than one market.

Also the effect of capital structure on bid ask spread.

Adverse selection, brokerage coverage, and trading activity on the Tokyo Stock
Exchange
Hee-Joon Ahn, Jun Cai,

48
 Yasushi Hamao,*, Richard Y.K. Ho
Journal of Banking & Finance 29 (2005) 1483–1508

Many studies that conducted on the US financial markets have found evidence of
adverse selection costs due to information-based trading and focus on developing and
testing of microstructure models that measure this cost component of bid-ask spread,
moreover, a great interest have been aroused toward the determinants of information
production and analyst following and many of studies have a contradiction in results
from examining the joint and the cross-sectional determinants of adverse selection
costs and information production. In addition to the conflict in results regarding this
issue, the differences in the structure between Japanese brokerage industry and US
markets regarding the limit order mechanisms, corporate ownership structure, and
incentive structures offer the opportunity to shed new light on the contradictory
empirical evidence from pervious studies on the determinants of adverse selection
costs.

So this study, first, estimate the adverse selection cost component of the bid–ask
spread using three of the microstructure models developed by Glosten and Harris
(1988); De Jong et al. (1996), and Madhavan et al. (1997), then it examine by using
an ordinary least squares (OLS) framework how the estimation of adverse selection
costs are cross-sectionally related to various firm and ownership characteristics and
through a simultaneous equation framework how adverse selection costs, brokerage
coverage, and trading activity are jointly determined.

In this study the sample period is covered from July 1 to October 31, 2001, and from
the Nikkei Economic Electronic Database System (NEEDS) historical tick they
obtained real-time TSE trades and quotes data, also the average daily closing price
and the trading volume in multiples of minimum trading units (MTU) are also
calculated from the tick data. The details about the ownership structure from the
NEEDS Corporate Financial Affairs dataset, so they obtained the information about
shareholding fro each of the sample stocks for the fiscal year ending no later than 31
March 2001. They also identify the number of brokerage firms providing earnings
estimated for each fiscal year between April 1, 2000 and Match 31, 2001 with the
forecasting horizon being 1-3 years, these data obtained from the international edition
of the I/B/E/S dataset (they used brokerage coverage instead of analyst following

49
because the I/B/E/S dataset does not provide the analyst names for each of the
earnings estimate figures entered in the dataset). Their sample was subject to filtering
process which at the end become consists of 930 stocks, which then partition into
three subgroups based on the tick sizes.

They applied the ordinary least square method to estimate the parameters for both
models of Glosten and Harris (1988) and De Jong et al. (1996) (which thereafter
DNR), and used generalized method of moments to estimate those of the model of
Madhavan et al. (1997) (which thereafter MRR). They found the adverse selection
cost as proportion to the total spread range from 51.9% to 63.9% for the DNR model
compared with 45.7% to 82.2% for the GH model.

They used the ordinary least squares method to get a preliminary insight on the cross
sectional determinants of adverse selection cost and then they used the three-stage
least squares regressions that account for the potential endogeneity that is to examine
the joint determination of adverse selection, brokerage converge, and trading volume.
They found from ordinary least squares that there are significant relations between
adverse selection costs and firm and trading characteristics (Firm size, share price,
return volatility, and trading volume) as well as the brokerage coverage. But the
ownership variables turn out to be insignificant. From simultaneous equation system
they found that while brokerage coverage reduces a firm’s adverse selection costs,
adverse selection costs increase brokerage coverage and this is because firms with
high adverse selection costs provide brokerage firms an opportunity to earn greater
profits. Moreover, they also found that higher trading volume lowers adverse selection
costs and higher adverse selection costs reduce trading volume. Finally, the trading
activity increases brokerage coverage while brokerage coverage also increases trading
activity.

Ideas: Our study has also uncovered new issues that need to be resolved. In
particular, while ownership structure variables are highly correlated with the extent of
brokerage coverage in Japan (as they are for US stocks), they have virtually no
explanatory power for the determinants of adverse selection costs on the TSE.
Institutions holding equity positions in US firms are primarily mutual funds and
pension funds who presumably adjust their portfolios fairly often to meet liquidity

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demands or to react to new information (Keim and Madhavan, 1995). Institutions
holding equity positions in Japanese firms are primarily commercial banks and
insurance firms and are long-term and stable shareholders; as a result, institutional
holdings serve as only a weak proxy for institutional or informed trading on the TSE.
If it is institutional trading rather than institutional holdings that are more closely
related to adverse selection costs on the TSE, then more work needs to be done to find
better proxies for institutional trading and to directly examine the relation between
institutional trading and adverse selection costs.

Another interesting issue that has yet to be explored is the joint determination of
institutional ownership and brokerage coverage. As suggested by O_Brien and
Bhushan (1990), statistical or analytical models that treat institutional ownership as
exogenous are misspecified if institutions are influenced by analyst behavior and vice
versa. This issue will become more important for Japanese firms in the future as they
gradually unwind their cross-shareholdings and as investment trusts and pension
funds, individual investors, and foreign investors emerge as more important
shareholders (Inoue, 2000).

Idea: applying the same idea on LSE in UK

In page 1488 they talked about models used in microsturcture.

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 Competing market makers,liquidity
provision,and bid–ask spreads
Oleg Bondarenko
Journal of Financial Markets 4 (2001) 269–308

Market makers or dealers play an important role in financial markets in providing

liquidity, and since their behaviour has effect on the short term dynamics of securities
prices it was of great interest to trader, regulators, and researches.

Moreover, many of market microstructure’s researches have often considered market

makers’ trading behaviour as perfectly competitive, and do not deal with strategic
aspects of market makers behaviour. So models used in these researches assumed
market makers are simply to be perfect competitors who provide liquidity at prices
that earn them a zero profit. But in fact market makers post rather noncompetitive
prices and that they do earn positive profits. Also these standard competitive models
cannot explain how market makers may be able to cover substantial fixed costs that
result from making a market in a security.

In addition, many literatures investigated the strategic trading behavior of market

makers in securities markets under adverse selection, but they analyzed market
makers’ trading behaviour in a static framework, at a point in time, and do not address
the effects of such a behavior on transaction prices over time.

So this paper, studies trading behavior of market makers in a dynamic microstructure

model with asymmetric information, in other words, he developed a dynamic market
microstructure model of liquidity provision in which M strategic market makers
compete in price schedules for order flow from informed and uninformed traders.

In this study he allowed imperfect competition of M profit maximizing market

makers by extended the Kyle (1985) sequential market. And amid to investigate
whether findings of single period models of imperfect competition are robust to the
introduction of multiple rounds of trading, and to study the consequences of imperfect
competition of market makers for the intertemporal properties of transaction prices
and to derive testable restrictions.

From the model that he developed, he found that when the number of market makers
equals or exceeds three, there exists a unique linear equilibrium and this equilibrium
is symmetric and characterized by simple recursive strategies of the market

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participants. Under this equilibrium market makers post price schedules that are
steeper than the efficient ones and earn strictly positive expected profits, but when M
(number of strategic market makers) reaches to infinity, the equilibrium converges to
the zero-profit sequential equilibrium in Kyle (1985). He found also that the bid–ask
spreads can be decomposed into two components, one due to adverse selection in the
market and the other due to imperfect competition between market makers, and these
two components are proportional to each other with a coefficient of proportionality
depending on the number of market makers, implying that the number of market
makers is an important cross-sectional determinant of the bid–ask spread. Also he
derived a new empirical measure of market competitiveness which can be estimated
from the history of transaction prices and trading volumes, and based on this measure
a comparison of different markets can be an interesting direction for future empirical
research. Moreover, this paper showed that the continuous market with a finite
number of market makers is infinitely tight and it has the same resiliency but lower
market depth, compared with the continuous market in Kyle (1985).

Liquidity measures are mentioned in page 294, and the proposition 5 in this paper
account for the fourth component of bid ask spread see page 289

Criticize in page 270 for many studies

Idea: In this paper, we study strategic aspects of market makers’ trading behaviour by
focusing on the classic Kyle’s environment. However, the basic model can easily be
extended to accommodate richer market structures. Such extensions may include (1)
multiple informed traders (as in Foster and Viswanathan (1993) and Holden and
Subrahmanyam (1992)),(2) price-sensitive demands of liquidity traders (as in
Bernhardt and Hughson (1997)) and (3) time-varying variance of liquidity demands.

Issues in Assessing Trade Execution Costs

Hendrik Bessembinder
Journal of Financial Markets
6 (2003) 233-257

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Trade execution costs considered very important to individual investors, portfolio
managers, those evaluating brokerage firm or financial market performance, and
corporate managers considering where to list their shares, and gain great interest from
researchers and academics. But the main short come of most studies examined the
trading costs and market quality comes form using publicly-available databases that
are limited to trade prices and quotations, that is, one shortcoming is that whether a
trade was initiated by a buyer or a seller must be imperfectly inferred from the data,
and the second one comes for the fact that trade prices can be readily compared to
quotes in effect at the trade report time.

So this study evaluated the practical impact of two methodological choices made
when estimating trading costs from public data: the procedure used to classify trades
as resulting from customer sell versus buy orders, and the relationship between trade
report times and the time of the quote chosen as a reference point. In addition, most of
studies that have adopted the five second lag recommended by Lee and Ready
generally use the adjustment both for selecting a quote to be used as a benchmark to
measuring effective trade execution costs and when inferring whether trades are buyer
or seller-initiated, even though, the optimal amount by which to adjust trade times
before comparing trade prices to quotes could differ depending on the application. So
this study assess the effect on measured trading costs of comparing trade prices to
quotes in effect from zero to thirty seconds prior to the trade report time.

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