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...negligible negligent attention Our condemnation of the easy use of imperfections in-the-capital-market is plea for the study of markets, not a claim that capital markets are 'perfect'.
Stigler (1967)
Introduction
The early literature in financial economics regarded transaction costs as bothersome details to be relegated under Stigler's class of "imperfections-in-the-capital-market." This practice has been reversed, however, with the growth in market microstructure literature. The relative levels of liquidity, volatility, and transaction costs in capital markets have drawn the attention of professionals in both academe and in the investment community. Furthermore, there has been increasing interest in the functioning of capital markets with financial liberalization policies installed in Eastern European countries and in the developing world. The gradual proliferation of capital markets worldwide has generated interest in their operational characteristics.
Issues addressed in the extant literature may be organized in three groups. First, what is the nature of costs incurred in transacting financial securities? Are there explicit and implicit components in addition to brokerage and commissions costs? Second, what are the underpinnings of transaction costs? Specifically, can the differing motivations of the two parties to a transaction (buyers and sellers) be reconciled within a common framework? Third, what do the empirical studies on transactions costs reveal? Does one type of market system dominate the other (e.g., auction versus dealer markets) with regard to transaction cost efficiencies? This selective survey focuses on the major component of transaction costs, namely, the bid-ask spread. It attempts to synthesize the literature and present a consensus on the answers to these questions.
The Nature of Transactions Costs
The convergence of interests of academicians and investment professionals on security market operations launched a stream of literature under the broad rubric, "market microstructure." Studies belonging to this genre focused on a number of related topics: differing market structures with divergent trading styles and attributes, measurements of transaction costs in these markets, volatility of their prices, and liquidity of their transactions. (1) In general, transaction costs are incurred in the transfer of property rights. They relate specifically to the cost of providing liquidity. Amihud and Mendelson (1991) identify the expected cost of illiquidity as the difference between the execution price and the expected price that would have prevailed in the absence of the transaction, i.e., the marginal price impact of the transaction. (2) Particular components of the costs of providing liquidity include the bid-ask spread, market impact costs, delay and search costs, and direct transactions costs. (3) The focus of this paper is exclusively on the bid-ask spread, because it is the largest observable component of transaction costs. Stoll (1992) points out that the market maker does not set the price of the security being traded. Instead the market maker provides the service of immediacy, i.e., the facility by which buyer and sellers can transact without delays. Thus, the economics of market making concerns the provision of this service and its related costs and only indirectly concerns the demand and supply of securities.
Components of the Bid-Ask Spread
Figure 1 delineates the different components of the bid-ask spread as first defined in Bagehot (1971) and identified in Loeb (1989). The basic bid-ask spread is the difference between the ask (dealer's selling/trader's buying) quote and the bid (dealer's buying/trader's selling) quote. The dealer may extract price concession from the trader in one of two forms depending on whether the trader is buying or selling securities, i.e., further reduction in the bid quote when the dealer is required to buy more than the quantity implicit in the bid-ask spread or a further increase in the ask quote when the dealer is required to sell more than the quantity implicit in the bid-ask spread. The commission cost is the brokerage commission charged specifically to the transaction. There are also SEC taxes on sellers of securities and charges to clear transactions (Depository Trust Company).
[FIGURE 1 OMITTED]
Bagehot (1971) attributes the revenues of the individual dealer (market-maker) to the transactions of three groups of agents. The first group consists of traders possessing special information. The second group includes liquidity-seeking traders who have no special information but merely want to buy, i.e., convert cash into securities, or sell, i.e., convert securities into cash. The third group of traders believes that security prices have not as yet impounded some residual piece of information, but which, in reality, has already been reflected in prices.
The market-maker invariably loses to the first group by setting the bid (ask) quote higher (lower) than the price incorporating the insider's information. A trader with information that the true value of a security is less than the bid price will sell at this price. Thus, the dealer loses (i.e., total costs are greater than the revenues) to the trader with superior information. But the market-maker always gains from transactions with liquidity-motivated traders. The market-maker sets the spread in such a manner that the gains from liquidity traders more than compensate the losses to the informed traders. The market-maker clearly profits from the third group of traders, which believes that publicly available information has not yet been impounded into security prices. Stoll (1992) identifies the three components of the individual dealer's (market-maker) endogenous cost of operations. Order processing costs consist of fixed and variable components, such as the cost of space, cost of communications equipment, some labor costs; thus there are economies of scale associated with these costs. Risk bearing costs include the cost of carrying inventory. (4) For example, the dealer with excess (minimal) inventories can lower such risks by reducing (increasing) the bid quote (the trader's selling price) and the ask quote (the trader's buying price). Adverse information costs arise from the dealer's disadvantage in dealing with the trader with superior information. (5)
Conceptual Foundations of the Bid and Ask Prices
The theoretical bases for bid and ask prices depend on factors affecting the supply of dealer's services. The dealer is represented as an agent who seeks to minimize the costs of carrying inventories of securities (inventory-theoretic approach). Another stream of the literature focuses on the differential information between informed traders and the dealer (information-theoretic approach). The rest of this section builds these concepts and presents illustrative samples from each subgroup in the literature.
Inventory-Theoretic Approach
The determinants of bid-ask spreads have been analyzed in two separate frameworks. In a single dealer framework the market-maker/dealer has monopoly power on trading activities and consequently sets bid-ask prices (Amihud and Mendelson, 1980; Ho and Stoll, 1981). On the other hand, the individual market-maker/dealer is in a competitive environment in the multi-dealer framework (Ho and Stoll, 1983). In either case, the market-maker/dealer seeks to achieve the optimal inventory level by balancing the inventory carrying costs (excess inventory) against opportunity costs of lost sales (less inventory).
In the monopolist setting, arrivals of buy and sell orders are assumed to follow independent Poisson processes. There are upper bounds on the dealer's inventory holdings due to administrative rules or due to capital requirements (Amihud and Mendelson, 1980). The dealer faces two uncertainties: uncertainty of returns from holding inventories and the uncertainty relating to traders' demand for future trades (Ho and Stoll, 1981). (6) The dealer maximizes an objective function [average profit per unit time (Amihud and Mendelson, 1980) or expected utility of terminal wealth (Ho and Stoll, 1981)] by adjusting bid and ask quotes in a dynamic programming framework. The quoted bid and ask prices are shown to be dependent on the dealer's stock of inventory; these quotes are monotonic decreasing functions of the inventory on hand. The optimal policy for the dealer suggests a preferred inventory position. Furthermore, this optimal quoting policy is such that it is impossible to profit by speculation, which implies that prices do not deviate substantially from their true values (Amihud and Mendelson, 1980).
The dealer is assumed to form an estimate of the true price (P) of the stock based on the information available. [P.sub.b] and [P.sub.a] are the bid and ask quotes respectively. Define [P.sub.b] = (P - b) and [P.sub.a] = (P + a). If the goal is to liquidate inventory, the dealer reduces [P.sub.a] (or reduces a), thereby increasing investor demand, and reduces [P.sub.b] (or increases b), thereby reducing investor supply of the security. If the goal is to increase the inventory, the dealer increases [P.sub.a] (or increases a), thereby reducing investor demand, and increases [P.sub.b] (or reduces b), thereby increasing investor supply of the security. In the multiperiod model, the dealer adjusts components a and b over time in response to inventory changes. (7)
In the Ho and Stoll (1981) analysis the bid-ask spread ([P.sub.a] - [P.sub.b]) comprises two components. The first component is the risk-neutral spread that maximizes expected profits for the given stochastic demand function. The second component of the bid-ask spread is a risk premium that depends on transaction size, the variance of the stock's return, and the dealer's attitude to risk. The spread is independent of the inventory position, but price adjustment depends on inventories. For example, when inventories increase, the response by the dealer to liquidate inventories is to reduce both ask and bid prices; when inventories decrease, the response by the dealer to build inventories is to increase both the ask and bid prices. Finally, the authors demonstrate that the risk of our dealer is greater than the risk of the dealer facing certain demand because the uncertainty of transaction demand is not eliminated by his or her pricing strategy.
In the multi-dealer framework, the individual dealer recognizes that his or her welfare depends on the actions of other dealers (Ho and Stoll, 1983). It is assumed that dealers face stochastic stock returns and stochastic transactions of fixed size. The bid-ask quotes are shown to depend on the degree to which transactions are correlated across securities at a given point in time and in a given security over several time periods. Furthermore, bid-ask quotes depend on the anticipated actions of other dealers.
Information-Theoretic Approach
Studies in this genre have investigated auction structure (Copeland and Galai, 1983; Glosten and Milgrom, 1985) and sequential trading (Kyle, 1985). Copeland and Galai (1983) analyze the dealer's commitment to transact at the bid and ask price as a combination of put and call options (straddles). The dealer offers the prospective trader two out-of-the money options: a call option to buy at the ask price, [K.sub.b.A] > [S.sub.0] (the current value of the asset) and a put option to sell the security at bid price, [K.sub.B] [K.sub.A] or when S < [K.sub.B]. Within this framework, the authors show that the bid ask spread is positively related to the price level and the return variance and negatively related to measures of market activity, depth, and continuity. The bid-ask spread...
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