Bid-ask Spread and Market Microstructure : Are Narrow Spread Always Feasible ?

Title Bid-ask Spread and Market Microstructure : Are Narrow Spread Always Feasible ?
Author Michael Schwarz
Years December 2005


The theoretical basis This journal describes a problem where companies try to maintain narrow bid-ask spread even in a market for a security where an uninformed.

The viability of narrow bid-ask spread is important for a number of reasons. First, narrow spreads attract small uninformed inverstor and make it easier for arbitrageurs to provide liquidity. Second, transaction cost and in particular the magnitude of the bid-ask spread may have a significant impact on long term price levels.

Methods and Subjects investors who have private information about the security’s value.
Main Result The obvious advantage of LEM is that it eliminates a possibility that liquidity dries up due to widening spreads, of course, the specialist will have to have a sufficiently deep pocket in order to insure that

he can fulfil his commitment. It is straightforward to estimate the upper bound on the wealth

of the specialist so that he can survive a five standard deviation event.

Conclusion From the perspective of large institutional investors

the price impact is probably the most relevant measure of liquidity. It is not obvious if using LEM would lead to lower or higher price impact of large trades relative to other trading institutions. This is an important question for future research.



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