Trading costs are lower than previously thought

That market liquidity – the cost of trading – influences asset prices and trading strategies is well known, but it is difficult to measure. A new paper by Björn Hagströmer, accepted for publication in the Journal of Financial Economics, challenges the definition of one of the most widespread liquidity measures, the effective spread.

A common approach to measure transaction costs is to compare the purchase price to the perceived value of the security. For example, if a stock is worth SEK 10 and you buy it at SEK 10.01, your transaction cost is SEK 0.01 (or, in relative terms, 0.1%). This cost measure is known as the effective spread.

 

But how do you know that the value is exactly SEK 10 in the first place? There are many ways to find the value of a security, but few have the precision required for transaction cost measurement. The standard approach, in academic papers and the industry alike, is to assume that the value equals the average of the best prices quoted by buyers and sellers, known as the midpoint. In the example, if the lowest price to buy the stock is SEK 10.01 and the highest price to sell the same security is SEK 9.99, the midpoint is SEK 10.00.

 

In the paper “Bias in the Effective Bid-Ask Spread”, Björn Hagströmer challenges the use of the midpoint as a proxy for the fundamental value when measuring transaction costs. He argues that a more precise approximation may be achieved by factoring in the quantities available for trading at the best buy and sell prices. Even though the resulting adjustment is tiny relative to the stock value, it implies that effective spreads have been overestimated by 13 to 18% on average for large US stocks. For some stocks, the refined effective spread is almost half of the standard measure used.

 

Read the full paper here: https://ssrn.com/abstract=2939579.