On the importance of timing specifications in market microstructure research

Abstract

This paper highlights the importance of timing specifications in empirical market microstructure studies. Small changes in the data matching process and the timing specification of economic variables can significantly alter the outcomes of empirical research. Using the methodology developed by Lee and Ready [1991. Journal of Finance 46(2) 733–746], we show that their “5-second rule” is not appropriate for matching quotes with transactions for NYSE stocks in the TAQ data set, and the prevailing quotes are the ones immediately before the trades. We demonstrate the significance of the timing specifications of economic variables using the Huang and Stoll [1997. Review of Financial Studies 10, 995–1034] spread decomposition model. Seemingly minor variations from the theoretical model result in severe biases in the estimated parameters. Correcting the timing errors provide much more realistic spread component estimates than those achieved in the literature.