ANATOMY OF THE BID-ASK SPREAD IN AN ORDER-DRIVEN MARKET: THE TRADE-OFF BETWEEN ADVERSE SELECTION COSTS AND NON-EXECUTION COSTS

Abstract

This paper sets out to provide a more general microstructure model for the analysis of bid-ask spread relating to the trade-off between adverse selection costs and non-execution costs in an order-driven market. Our model demonstrates that for traders on both sides, the bid-ask spread comprises of adverse selection costs and non-execution costs which arise endogenously from information variables in the limit order book. The numerical tests show that the changes in the depth, volatility and probability of informed trading in the limit order book are consistent with the hypothesized tradeoff between adverse selection costs and non-execution costs. Therefore, our model confirms that the trading mechanism within an order-driven market is indeed feasible for resolving the extreme liquidity imbalance, asset volatility and information asymmetry levels through adjustments to the quotes and spreads based on the trade-off, thereby fulfilling the trading motivation of each trader.