Abstract
There is a surprising absence of common factor variables in market microstructure models. In this study we extend Huang and Stoll's (1997) spread cost decomposition model to incorporate a market wide buying and selling pressure cost component. We find strong evidence that specialists take this common factor cost component into consideration when they set bid and ask quotes. Evidence that specialist firms take the next logical step and specifically manage their firm wide stock inventories is ambiguous. The common factor is found to be largest for securities with the highest trade frequencies. This size effect diminishes and becomes insignificant under the new decimal trading regime. The relative importance of the common factor spread component decreases as the pricing grid becomes finer, but remains highly significant.
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