Asset pricing and the bid-ask spread

Abstract This paper studies the effect of the bid-ask spread on asset pricing. We analyze a model in which investors with different expected holding periods trade assets with different relative spreads. The resulting testable hypothesis is that market-observed expexted return is an increasing and concave function of the spread. We test this hypothesis, and the empirical results are consistent with the predictions of the model.

Asset pricing and bid-ask spread

Market efficiency, long-term returns, and behavioral finance1The comments of Brad Barber, David Hirshleifer, S.P. Kothari, Owen Lamont, Mark Mitchell, Hersh Shefrin, Robert Shiller, Rex Sinquefield, Richard Thaler, Theo Vermaelen, Robert Vishny, Ivo Welch, and a referee have been helpful. Kenneth French and Jay Ritter get special thanks.1

An individual who chooses to serve as a market-maker is assumed to optimize his position by setting a bid-ask spread which maximizes the difference between expected revenues received from liquidity-motivated traders and expected losses to informationmotivated traders. By characterizing the cost of supplying quotes, as writing a put and a call option to an information-motivated trader, it is shown that the bid-ask spread is a positive function of the price level and return variance, a negative function of measures of market activity, depth, and continuity, and negatively correlated with the degree of competition. Thus, the theory of information effects on the bid-ask spread proposed in this paper is consistent with the empirical literature. THIS PAPER IS CONCERNED with the determination of bid-ask spreads in organized financial markets, where the trading is done through economic agents who specialize in market-making for a limited set of securities. The commitment made by dealers to buy or sell at the bid and ask prices, respectively, is analyzed as a combination of put and call options, and empirical results published in previous works are shown to be consistent with the model. While there have been several papers concerned with the bid-ask spread, no entirely satisfactory theory has yet emerged. Demsetz [10] was the first to formalize the problem. He treated the bid-ask spread as a (transaction) cost to the trader for immediacy, and analyzed it in a static supply and demand framework.

https://www.jstor.org/stable/pdfplus/2327580.pdf

Information Effects on the Bid‐Ask Spread

This paper provides an analysis of the predictable components of monthly common stock and bond portfolio returns. Most of the predictability is associated with sensitivity to economic variables in ...

https://www.jstor.org/stable/pdfplus/2937686.pdf

The variation of economic risk premiums

Risk and return

The stock market is in the midst of an era of change unparalleled since the Great Depression, long-standing institutions — including the major stock exchanges — are being radically challenged by contemporary developments, and novel approaches to making markets for common stocks are appearing with increasing frequency. In addition, the Martin Report and the recent hearings of the Securities and Exchange Commission on the future structure of the equities market indicate that the regulatory climate surrounding the stock market can be expected to undergo serious change in the near future.

Competition and the Pricing of Dealer Service in the Over-the-Counter Stock Market

A popular hypothesis to explain the anomalous January returns of common stocks is based on the argument that there is considerable tax-loss selling by investors toward the end of the year. The purpose of this study is to test the tax-loss-selling hypothesis with data on Canadian stocks. Although the introduction of capital gains tax in Canada seems to have affected the behavior of stock returns, the findings do not support the proposition that taxinduced trading is the sole cause ofthe seasonality in stock returns in Canada. I. Introduction Over the past several years, a number of studies have shown that the returns on common stocks, in general, and the stocks of small companies, in particular, tend to be abnormally high during the month of January. Keim [10] demonstrated quite clearly that a very high percentage of the abnormal positive returns gener? ated on stocks with low market capitalizations occurs during January, with the returns during the first five trading days of the year accounting for most of the anomalous behavior. His results were recently confirmed by Roll [14], who re? ported that around 37 percent of the annual differences in the returns on the equally-weighted and value-weighted indices of NYSE and AMEX stocks is ac? counted for by what happens in the five trading days from the last trading day in December through the fourth trading day in January. A popular hypothesis to explain the so-called "January effect" in stock re? turns is based on the argument that there is considerable end of the year tax-lossselling by investors. Originally proposed by Wachtel [19], it asserts that inves? tors try to realize losses towards the end of the year to reduce their taxes, thereby putting downward pressure on stock prices. According to the hypothesis, once

Seasonality in Canadian Stock Prices: A Test of the "Tax-Loss-Selling" Hypothesis

This paper examines the determinants of underwriters' spreads on tax exempt bond issues. In particular, it investigates the effect on spreads of differences in issue quality, term to maturity, and size. In addition, changing money market conditions and variations in the degree of competition among underwriters of tax exempts are analyzed for their influence on spread behavior. The relationships are studied for virtually all state bond issues sold between July 1, 1959 and December 31, 1965. The principal method of investigation is multiple regression analysis.

Richard R. West

Papers

Risk and return

Competition and the Pricing of Dealer Service in the Over-the-Counter Stock Market

Seasonality in Canadian Stock Prices: A Test of the "Tax-Loss-Selling" Hypothesis

Determinants of Underwriters' Spreads on Tax Exempt Bond Issues **

The economics of the stock market