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Relation between Bid-Ask Spread, Impact and Volatility in Order-Driven Markets
[journal article]
Abstract We show that the cost of market orders and the profit of infinitesimal market-making or -taking strategies can be expressed in terms of directly observable quantities, namely the spread and the lag-dependent impact function. Imposing that any market taking or liquidity providing strategies is at bes... view more
We show that the cost of market orders and the profit of infinitesimal market-making or -taking strategies can be expressed in terms of directly observable quantities, namely the spread and the lag-dependent impact function. Imposing that any market taking or liquidity providing strategies is at best marginally profitable, we obtain a linear relation between the bid-ask spread and the instantaneous impact of market orders, in good agreement with our empirical observations on electronic markets. We then use this relation to justify a strong, and hitherto unnoticed, empirical correlation between the spread and the volatility per trade, with R2s exceeding 0.9. This correlation suggests both that the main determinant of the bid-ask spread is adverse selection, and that most of the volatility comes from trade impact. We argue that the role of the time-horizon appearing in the definition of costs is crucial and that long-range correlations in the order flow, overlooked in previous studies, must be carefully factored in. We find that the spread is significantly larger on the NYSE, a liquid market with specialists, where monopoly rents appear to be present.... view less
Classification
Public Finance
Free Keywords
Microstructure; Bid-ask spread; Impact; Liquidity
Document language
English
Publication Year
2007
Page/Pages
p. 41-57
Journal
Quantitative Finance, 8 (2007) 1
DOI
https://doi.org/10.1080/14697680701344515
Status
Postprint; peer reviewed
Licence
PEER Licence Agreement (applicable only to documents from PEER project)