THE COMPONENTS OF THE BID-ASK SPREAD - A GENERAL-APPROACH

A simple time-series market microstructure model is constructed within which existing models of spread components are reconciled, We show th at existing models fail to decompose the spread into all its component s. Two alternative extensions of the simple model are developed to ide ntify all the components of the spread and to estimate the spread at w hich trades occur. The empirical results support the presence of a lar ge order processing component and smaller, albeit significant adverse selection and inventory components. The spread components differ signi ficantly according to trade size and are also sensitive to assumptions about the relation between orders and trades.