Estimating the effect of transaction costs using tick-size as a proxy

Espen Sirnes

doi:10.7557/22.5769

Abstract

A method is proposed for estimating the effect of transaction costs on volatility, using the tick-size as proxy. The method follows three steps: 1) collect only the cases where the tick-size changes from one regime to another, 2) estimate the effect with and without the order book size, and 3) use local data on tick-size and volatility, but instruments from international markets. The first step handles stationarity and dependence. The second step is used to infer the effect of a symmetric transaction cost as tick-size is a revenue and not a cost for liquidity providers. A regression with and without the order book may therefore indicate how much this asymmetry is likely to affect the result. The third step handles endogeneity. The method is applied on intraday data from the Norwegian Stock Exchange (OSE). The results show that both the tick-size and inferred transaction costs seems to have surprisingly little impact on volatility.

Highlights

Understanding how transaction costs affect the market is important in order to understand how exchanges should manage their markets in the best way possible and how government should regulate financial markets
This study shows that the tick-size and transaction costs have surprisingly little impact on market volatility
It follows immediately from (Grossman and Stiglitz, 1980) that price volatility depends on the ratio of noise traders to informed and uninformed traders

Summary

Introduction

Understanding how transaction costs affect the market is important in order to understand how exchanges should manage their markets in the best way possible and how government should regulate financial markets. The approach taken in this study is to use the tick-size, the smallest permissible difference between ask and bid quotes, as a proxy for transaction costs. With this approach, every traded stock is a natural experiment. The underlying problem is that if the tick-size and price do not change, the observation is only a version of the previous. We can infer how volatility would be affected if the interaction between liquidity provision and tick-size was reversed, as we would expect with a symmetric transaction cost. There may be endogeneity between this price and volatility, and between order book size and volatility This problem can be addressed by using instrumental variables.

Literature

Description of the variables

Model and results

Summary and conclusion

Findings