2007/12/14 by Matthieu Wyart, Jean–Philippe Bouchaud, Julien Kockelkoren +2 · 4 citations
Business, Management and Accounting · Economics, Econometrics and Finance · #Bid price #Bid–ask spread #Complex Systems and Time Series Analysis #Corporate Finance and Governance #Econometrics #Economics #Economy #Financial Markets and Investment Strategies #Financial economics #Implied volatility #Market liquidity #Market maker #Market microstructure #Monetary economics #Order (exchange) #Order book #Price discovery #Stock market #Volatility (finance)
paper · doi:10.1080/14697680701344515
openalex publication_date 2007/12/14 · openalex created_date 2016/06/24 · openalex updated_date 2026/07/29
We show that the cost of market orders and the profit of infinitesimal market-making or -taking strategies can be expressed in terms of directly observable quantities, namely the spread and the lag-dependent impact function. Imposing that any market taking or liquidity providing strategies is at best marginally profitable, we obtain a linear relation between the bid–ask spread and the instantaneous impact of market orders, in good agreement with our empirical observations on electronic markets. We then use this relation to justify a strong, and hitherto unnoticed, empirical correlation between the spread and the volatility per trade, with R 2s exceeding 0.9. This correlation suggests both that the main determinant of the bid–ask spread is adverse selection, and that most of the volatility comes from trade impact. We argue that the role of the time-horizon appearing in the definition of costs is crucial and that long-range correlations in the order flow, overlooked in previous studies, must be carefully factored in. We find that the spread is significantly larger on the NYSE, a liquid market with specialists, where monopoly rents appear to be present.