Do Information Releases Diminish Equity Bid-Offer Spreads?

Abstract

Stock market makers are afraid that informed insiders will take advantage of them in trade. To protect themselves, they may increase the bid-offer spread to include a fee for the adverse selection risk . If set correctly, market makers will share in profits from others trading on private information and can distribute the remaining costs among other market participants. If market makers protect themselves this way, then when the risk of informed trading is relatively low, the bid-offer spread should decline. The risk of informed trading will be relatively low when the difference in public and private information shrinks. Filings with the Securities and Exchange Commission (SEC) and conference calls where corporate earnings are announced and discussed should be events that diminish this difference. Because smaller companies attract less scrutiny, they may experience relatively larger changes in this information distance after these releases. This paper finds weak evidence that spreads diminish when this information is released and a weak size effect. It hypothesizes that the bid-offer spread seems to the spread is smaller than has previously been estimated does or possibly does not exist. Estimates of this spread are actually a statistical illusion created by the structural form of earlier estimation techniques.