Order Flow, Trading Costs and Corporate Acquisition Announcements

Abstract

The bid-ask spread is an important element of investors' transactions costs. Theoretical papers decompose the spread into adverse selection, inventory cost, and order processing cost components. The order processing cost component compensates the stock exchange specialist for providing immediacy to buyers and sellers. The inventory cost component compensates the specialist for the risk of holding an inventory of a stock. The inventory component is larger for high-priced stocks, stocks which trade infrequently, and stocks with a relatively uncertain value. This study focuses on the adverse selection component of the spread, which compensates the specialist for losses to traders who have inside information. Prior theoretical work suggests that the adverse selection component will be larger, the greater the proportion of traders who have private information. The specialist will widen the spread in response to a perceived increase in the probability that the next trader is privately informed. Prior studies also suggest that privately informed traders will generally trade larger amounts than uninformed traders. Consequently, trade size should impart information about the probability that a trader is privately informed.