Adverse Selection Cost Components Research Articles

The adverse selection cost component of the spread of Brazilian stocks

This study analyzes the adverse selection cost component embedded in the spreads of Brazilian stocks. We show that it is higher than in the U.S. market and presents an intraday U-shape pattern (i.e., higher at the beginning and at the end of the day). In addition, we investigate the relationships of the adverse selection cost with a firm's characteristics. We find that stocks listed in the highest corporate governance levels do not have the lowest costs. On the other hand, the liquidity of shares, the trade size and the market value of the firm are directly correlated with this cost.

A Comparison of China's Main Board and Growth Enterprise Market Board — Market Microstructure Approach

We compare the market quality of the newly established, second board of the China stock market, the Growth Enterprise Market (GEM) with the Main Board, and examine its impact on the Main Board from the market microstructure perspective. Using the newly available transaction level data, several findings emerge. First, trading activities of the Main Board stocks increase after the introduction of GEM Board, suggesting that the establishment of GEM is not at the expense of the Main Board but instead enhance the overall trading activities in China. Pricing error variances are not different in the two Boards, while GEM stocks have larger adverse selection cost component of bid-ask spread and higher probability of information-based trading which indicate a larger information asymmetry among traders, on average in GEM stocks than those in the Main Board. Interestingly, we find that the 15 min returns of Main Board stocks strongly lead that of GEM stocks but the GEM board only weakly leads Main Board, evidencing information transmission from the Main Board to the GEM. Overall, our findings suggest that the market quality of the GEM is sufficiently good to provide an important, alternative listing venue for high potential firms in China.

Short-Selling, Uptick Rule, and Market Quality: Evidence from High-Frequency Data on Hong Kong Stock Exchange

Much empirical research has been conducted concerning the effect of short-selling on market quality and volatility. However, the evidence is inconclusive and still a matter of debate. Using intraday data in a pure order-driven market we show that allowing for short-selling decreases the adverse selection costs for less-visible firms, firms with less analyst coverage, larger adverse-selection cost component of the bid-ask spread, low price per share, and high relative tick size (given the same market capitalization). Allowing for short-selling also decreases (increases) intraday volatility for less- (more-) visible stocks. In addition we document that with the uptick rule in place (not in place) there is not statistically significant difference in liquidity (intraday volatility) between stocks that are allowed for short-selling and those that are not.

Electronic Communication Networks, Market Makers, and the Components of the Bid-Ask Spread

We investigate why trading costs through Electronic Communication Networks (ECNs) are lower than trading costs with market makers through estimating the components of the bid-ask spread. Additionally, we show how the composition and size of bid-ask spreads change with the market environment. We find the adverse selection cost component of the bid-ask spread to be lower when ECNs are alone at the inside compared to when market makers are alone at the inside. The magnitude or size of the inside spread is largest during periods of high volatility but smallest when stock returns approach zero.

Time Varying Three Way Decompositions of Posted Spreads

In this study, Huang and Stoll's (1997) three way decomposition model for posted spreads is estimated using a data set with 10 stocks traded at Stockholmsborsen (SB), randomly selected from in the OMX stock index. The Huang and Stoll (1997) model encompasses statistical and indicator models by for example Ross (1984), Stoll (1989), George et al (1991), Glosten and Harris (1988), decomposing posted spreads into order processing, adverse selection and inventory cost components. In this study fixed probabilities of reversed trades ranges from 12.38 percent to 21.25 percent. This means that trade continuations are highly probable. Even so, this study supports the Huang and Stoll (1997) model. The signs of estimated adverse selection cost component coefficients are positive for all stocks ranging from 0.31 percent to 10.75 percent. No bunching procedure is used, which probably would have yielded higher adverse selection coefficients. Also, this study finds time of day, or diurnal, patterns in the probability of reversed trades. However, this pattern does not affect the coefficients for the adverse selection or inventory cost components. But diurnal probabilities of reversed trades do have an important implication for the size of expected changes in the mid quote. Diurnal patterns in the probability of reversed trades support earlier notions of larger spreads and higher transaction volumes at the opening and supports earlier findings of informed trading occurring during the first 15 minutes after the opening.

Modeling the bid/ask spread: measuring the inventory-holding premium

The need to understand and measure the determinants of market maker bid/ask spreads is crucial in evaluating the merits of competing market structures and the fairness of market maker rents. This study develops a simple, parsimonious model for the market maker's spread that accounts for the effects of price discreteness induced by minimum tick size, order-processing costs, inventory-holding costs, adverse selection, and competition. The inventory-holding and adverse selection cost components of spread are modeled as an option with a stochastic time to expiration. This inventory-holding premium embedded in the spread represents compensation for the price risk borne by the market maker while the security is held in inventory. The premium is partitioned in such a way that the inventory-holding and adverse selection cost components, as well as the probability of an informed trade, are identified. The model is tested empirically using Nasdaq stocks in three distinct minimum tick size regimes and is shown to perform well both in an absolute sense and relative to competing specifications.

Modeling the Bid/ask Spread: Measuring the Inventory-holding Premium

The need to understand and measure the determinants of market maker bid/ask spreads is crucial in evaluating the merits of competing market structures and the fairness of market maker rents. After providing a brief review of past work, this study develops a simple, parsimonious model for the market maker's spread that accounts for the effects of price discreteness induced by minimum tick size, order-processing costs, inventory-holding costs, adverse selection, and competition. The inventory-holding and adverse selection cost components of spread are modeled as an option with a stochastic time to expiration. This inventory-holding premium embedded in the spread represents compensation for the price risk borne by the market maker while the security is held in inventory. The premium is partitioned in such a way that the inventory holding and adverse selection cost components and the probability of an informed trade are identified. The model is tested empirically on a sample of NASDAQ stocks over three distinct tick size regimes and is shown to perform well.

Earnings Predictability, Information Asymmetry, and Market Liquidity

We investigate the relation between earnings predictability, information asymmetry and the behavior of the adverse selection cost component of the bid‐ask spread around quarterly earnings announcements for NASDAQ firms. While we find an increase in the adverse selection component of the bid‐ask spread on the day of and the day prior to quarterly earnings announcements for firms with less predictable earnings, we find no evidence of such changes for firms with more predictable earnings. During a non‐announcement period, we find that firms with relatively less predictable earnings have consistently higher total bid‐ask spreads than firms with more predictable earnings. This finding suggests that firms with relatively less predictable earnings have a higher cost of equity capital than comparable firms with more predictable earning streams, ceteris paribus. Hence, earnings predictability may be a legitimate concern of managers who wish to minimize their cost of equity capital at least as it pertains to bid‐ask spreads.

Earnings Announcements and the Components of the Bid‐Ask Spread

ABSTRACTThis study investigates the behavior of the components of the bid‐ask spread around earnings announcements. We find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Our results suggest that the directional change in the total bid‐ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid‐ask spread, even when they result in increased information asymmetry.

Earnings Announcements and the Components of the Bid-Ask Spread

This study investigates the behavior of the components of the bid-ask spread around earnings announcements. The authors find that the adverse selection cost component significantly increases surrounding the announcements, while the inventory holding and order processing components significantly decline during the same periods. Their results suggest that the directional change in the total bid-ask spread depends on the relative magnitudes of the changes in these three components. Specifically, the decreases in inventory holding costs and order processing costs imply that earnings announcements may have an insignificant impact on the total bid-ask spread, even when they result in increased information asymmetry.Copyright 1996 by American Finance Association.