5.2 Bid–Ask Spread
In some stock exchanges (e.g., NYSE), market makers play an important role in facilitating trades. They provide market liquidity by standing ready to buy or sell whenever the public wishes to buy or sell. By market liquidity, we mean the ability to buy or sell significant quantities of a security quickly, anonymously, and with little price impact. In return for providing liquidity, market makers are granted monopoly rights by the exchange to post different prices for purchases and sales of a security. They buy at the bid price Pb and sell at a higher ask price Pa. (For the public, Pb is the sale price and Pa is the purchase price.) The difference Pa − Pb is call the bid–ask spread, which is the primary source of compensation for market makers. Typically, the bid–ask spread is small—namely, one or two cents.
The existence of a bid–ask spread, although small in magnitude, has several important consequences in time series properties of asset returns. We briefly discuss the bid–ask bounce—namely, the bid–ask spread introduces negative lag-1 serial correlation in an asset return. Consider the simple model of Roll (1984). The observed market price Pt of an asset is assumed to satisfy
where S = Pa − Pb is the bid–ask spread, is the time-t fundamental value of the ...