Relation between Bid-Ask Spread, Impact and Volatility in Order-Driven Markets

Journal article | Zeitschriftenartikel

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.

Object Details

• Extent: Seite(n): 41-57
• Language: Englisch
• Notes: Status: Postprint; begutachtet (peer reviewed)

References and Relationships

• Bibliographic citation: Quantitative Finance, 8(1)

Classification and Topics

• Subject: Wirtschaft ; Öffentliche Finanzen und Finanzwissenschaft

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Bouchaud, Jean-Philippe ; Vettorazzo, Michele ; Kockelkoren, Julien ; Wyart, Matthieu ; Potters, M
• Event: Veröffentlichung
• (where): Vereinigtes Königreich
• (when): 2007

Further information

• DOI: https://doi.org/10.1080/14697680701344515
• URN: urn:nbn:de:0168-ssoar-221056
• Rights: GESIS - Leibniz-Institut für Sozialwissenschaften. Bibliothek Köln
• Last update: 21.06.2024, 4:27 PM CEST