Components of bid/ask spread and determinants of limit order distribution

Abstract

Much theoretical and empirical research suggests that the design of securities markets is a crucial factor of securities market performance in facilitating processes of price discovery. The focus of the studies points fingers at the question of how can we design the trading procedures to reflect a true equilibrium price and to stabilize the securities markets but not to weaken efficiency of the markets. Securities market microstructure is an intricate and multifaceted subject. Especially, estimating the components of the bid/ask spread and the determinants of limit order distribution is a very important issue. Bid/ask spread is a transaction cost for demanding immediacy. There are several components in designing securities markets, such as trading mechanisms, market makers and circuit breakers. According to the mechanisms of trading and the characteristics of market makers, the components of the bid/ask spread could be determined differently. The major focus of the recent studies has been on estimating the bid/ask spread and its components using transaction returns. Among the components of the securities market design, circuit breakers have been recommended as a mechanism for market stabilization. The most common and perhaps most primitive type of circuit breakers is a price limit system which is applied in many securities markets. Price limits, which restrict daily price changes of a stock within a prespecified bound, are a crucial factor that affects characteristics of order flow as well as underlying stock price movements. Since a price is determined depending on the order flow, the interrelationship between price limits and order flow is an interesting issue to the policy makers in designing securities markets, and to individual and institutional investors who draw implications for their portfolio management. Chapter 2 briefly discuss components of the bid/ask spread and determinants of limit order flows. More specifically, the present thesis has emphasized...