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INCORPORATING PRICE-RELEVANT INFORMATION BETWEEN QUOTES AND TRADES: A NEW MEASURE OF THE EFFECTIVE BID-ASK SPREAD

This paper provides a new measure of the effective bid-ask spread in a dealer-auction. Our measure differs from the "quote-to-trade" measures derived from direct comparisons of trade prices with bid and ask quotes by explicitly incorporating the price effect of information arriving between the time a set of quotes is posted and the next trade, which will tend to be reflected in the trade price but not in the quotes, as well as the price effect in the situation vice versa. For NYSE/AMEX stocks in 1993, our measure yields estimates of the effective spread that are lower than estimates obtained using the quote-to-trade measure, and our estimates are, on average, only 31 percent of the quoted spread. We also find a U-shaped intraday pattern for our estimates of effective spread that is consistent with, but is much more pronounced than, the pattern that has been observed in previous studies. We provide a conjecture as to why this pattern may be related to the U-shaped intraday pattern observed in volume and volatility.