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The bid-ask spread is the difference between the ask (the lowest price at which someone is willing to sell an asset or security) and the bid (the highest price at which there is someone in the marketplace ready to buy it). The spread is often used as a measure of market uncertainty as well as market liquidity. The average of the bid-ask spread is also used as a measure of the consensus value of an asset. The term dates back to at least James Dolley, who used it in his March 1938 American Economic Review article to measure discontinuity in stock trading on the New York Stock Exchange, although the concept was probably in use before then.
The intuitive reason for the existence of a bid-ask spread is that there is disagreement among market participants as to the value of a security. However, there are other reasons for a bid-ask spread. For example, because buyers and sellers need not arrive simultaneously, market makers stand ready to buy securities from sellers and sell securities to buyers; the bid-ask compensates these market makers for the cost of holding inventory. Other causes could include the existence of an order-processing cost, or market makers might have to adjust their prices to protect themselves against the risk of trading with better informed agents; this is the adverse selection cost.
One problem with the use of the bid-ask spread is that the market might lack depth—that is, the ability of a trader to trade a large number of shares at the quoted price. Consequently, for average-sized trades, the bid-ask spread might not indicate expected transaction costs. Furthermore, if the potential price impact is asymmetric, the average of the bid-ask spread may not be useful as a measure of the current consensus value of the asset, either.
Alternate measures of liquidity have been suggested. Some of these are: (1) net trading range—that is, the difference between the high and low price less the change in price during a given trading period; (2) the effective bid-ask spread—that is, the distance between the average of the quoted bid-ask spread and the price at which the deal transacts; (3) turnover; and (4) the ratio of absolute returns to trading volume.
Empirically, bid-ask spreads have been linked to various factors such as the volume of trade, the cost of holding inventory, the degree of information asymmetry, and tick size. The first three factors follow immediately from the discussion above. The notion of tick size as a determining factor has acquired more prominence since the introduction of decimalization in secondary equity markets. Decimalization has led to smaller quoted and effective bid-ask spreads for most stocks. However, con-comitantly, there have been more small trades and fewer large trades, and the depth of the market has suffered, exacerbating the problems listed above with the use of the bid-ask spread as a measure of liquidity.
Bibliography:
- Angel, James. 1997. Tick Size, Share Prices, and Stock Splits. Journal of Finance 52 (2): 655–681.
- Dolley, James C. 1938. The Effect of Government Regulation in the Stock-Trading Volume of the New York Stock Exchange. American Economic Review 28 (1): 8–26.
- Korajczyk, Robert A., and Ronnie Sadka. 2006. Pricing the Commonality across Alternative Measures of Liquidity. August. Working Paper, Northwestern University. http://ssrn.com/abstract=900363.
- Rhodes-Kropf, Matthew. 2005. Price Improvement in Dealership Markets. Journal of Business 78: 1137–1172.
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