Spread decomposition with common spread components

Thomas Henker (Australian School of Business, Banking and Finance, University of New South Wales, Sydney, Australia)
Martin Martens (Erasmus University, Rotterdam, The Netherlands)

International Journal of Managerial Finance

ISSN: 1743-9132

Publication date: 6 April 2010

Abstract

Purpose

This paper aims to incorporate a market wide buying and selling pressure cost component into a spread decomposition model as spread cost component.

Design/methodology/approach

The paper extends a commonly used trade indicator spread decomposition model to include a component common to all stocks of a specialist firm and a market wide component common to all stocks.

Findings

Strong evidence is found that specialists consider this common factor cost component when they set bid and ask quotes. Some specialist firms also take the next logical step and specifically manage their firm wide stock inventories. The common factor is in percentage terms largest for securities with the highest trade frequencies.

Research limitations/implications

The relative importance of the common factor spread component decreases as the pricing grid becomes finer, but remains highly significant under the decimal trading regime.

Originality/value

This is the first study to document not‐security‐specific spread cost components that are common to all stocks for which a specialist firm makes markets and to all stocks in the market. Using the model it is shown that market wide uncertainty translates into spreads of individual securities.

Keywords

Citation

Henker, T. and Martens, M. (2010), "Spread decomposition with common spread components", International Journal of Managerial Finance, Vol. 6 No. 2, pp. 88-115. https://doi.org/10.1108/17439131011032031

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Publisher

:

Emerald Group Publishing Limited

Copyright © 2010, Emerald Group Publishing Limited

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