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Rev Fin 1991; 4:623-656
© 1991 the Society for Financial Studies

Article

Estimation of the bid - ask spread and its components: a new approach

TJ George1, G Kaul2 and M Nimalendran3
1 Ohio State University, Ohio, USA
2 School of Business Administration, The University of Michigan, Ann Arbor, MI 48109, USA
3 University of Florida, Florida, USA

Abstract

We show that time variation in expected returns and/or partial price adjustments lead to a downward bias in previous estimators of both the spread and its components. We introduce a new approach that provides unbiased and efficient estimators of the components of the spread. We find that between 77 and 97 percent of the downward bias in previous spread estimate is caused by time variation in expected returns. More importantly, the adverse-selection component, though significant, accounts for a much smaller proportion (8 to 13 percent) of the quoted spread, at least for small trades, than the proportion (over 40 percent) previously reported in the literature. Order processing costs are the predominant component of quoted spreads.


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